Inflation and Paper Money: An Historical Perspective

Abstract

The return of inflation has revived some of the policy discussions that typically accompany inflationary episodes. Most of these discussions ignore the more fundamental question of why we operate in a world of unbacked, or fiat, money? This article, after providing a basic introductory model of how the monetary system works and the impacts inflation can have on the economy, provides the reader three historical episodes where the question of what a proper currency is was debated. These are the founding debates where the coinage clause was debated, the Civil War, where the Legal Tender Act was debated in Congress, and the Great Depression, where the Gold Reserve Act was also debated in Congress. Associated with the Civil War era is also a set of cases known as the Legal Tender Cases. In all these debates and discussions, proponents of paper money argued the necessity for the federal government to have a temporary flexible solution to an impending economic crisis. Opponents argued that paper money was an evil that cause inflation and the associated harms that resulted. The goal of this article is to bring these debates back into focus as we head into another period of inflation and attempts at controlling it.

Keywords: Inflation, Fiat Currency, Legal Tender

JEL Classification: E52, E58, N11, N22