How our monetary system works – in plain words

Almost every finance headline rests on five ideas: money, interest, inflation, central bank, real assets.

Money is a promise

A banknote is paper; its value is the trust that everyone accepts it tomorrow. Since 1971 no major currency is backed by gold – this is called fiat money. The European Central Bank (ECB) is tasked with keeping the euro stable.

Bretton Woods and 1971

In 1944 the dollar was fixed to gold (35 $ an ounce) and all other currencies to the dollar. When the US printed more dollars than it had gold, President Nixon ended convertibility on 15 August 1971. Since then every currency is fiat money – a promise backed by the state, not by gold.

Where new money comes from

Most new money is created when a bank grants a loan and credits your account; it disappears again when the loan is repaid. The central bank steers this through interest rates.

The Cantillon effect

New money reaches those closest to the source first – banks, the state, owners of assets – who spend or invest it before prices rise. Wages and savings feel it last, when houses, shares and gold are already dearer. Owners of real assets benefit; savers in cash pay the bill; late buyers buy expensive.

The economic machine

Ray Dalio describes the economy as gears: every spend is someone else’s income. Productivity grows slowly, short credit cycles (5–8 years) and a long debt cycle (decades) swing around it. When debt outgrows income, central banks usually choose to create money – which brings us back to Cantillon.

Interest: accelerator and brake

Higher rates make credit expensive and slow price rises; lower rates make credit cheap and let prices rise faster. That is why ECB decisions move your mortgage, your savings and, indirectly, your insurance.

Inflation

The ECB aims for 2 % a year. At 2 %, money loses about half its purchasing power in 35 years; at 4 %, in about 18.

Monetary assets vs. real assets

Cash, deposits and classic life insurance are monetary assets: predictable, available, protected up to €100,000 per customer and bank – but eroded by inflation. Property, gold, company shares are real assets: protection over long periods, but volatile and not instantly liquid. Neither is “better” – it depends on what the money is for and when.