I thought I'd start off my first post with an editorial on the banking system. It all begins somewhere in the depths of time, when possibly a caveman or dirt farmer needed something urgently such as food and was unable to immediately trade for it. Some kind soul, call him KS, decided to give him the food, say, a chicken on a promise to replace the chicken at some point in the future. Thus was born the concept of credit, a pivotal point in the development of mankind. The dirt farmer, call him DF, gave KS a marker which could be exchanged for a chicken next year when DF would successfully have raised a flock. In the meantime, KS needed something else, and traded DF's marker for it. The person accepting the chicken marker knew DF and felt secure in DF's ability to provide a chicken in the future. Guess what? The marker just kept changing hands and nobody came to DF to collect the chicken. DF was no idiot, and saw what was happening. He issued more markers, traded them for goods, and never had to pay the debt back. In reality, he noticed that only about 10% of his markers ever came back to him with people collecting their chicken, so if he had 100 chickens he felt secure issuing 1000 markers. This approach is known as a fractional reserve system. As you have almost certainly figured out by now, DF became what we today call a banker.
Instead of using chickens and markers, a modern banking system used gold and notes/coins. The really early systems just combined the two and used coins made out of precious metals such as gold and silver. Nixon took the USA and thus the world off of the gold standard in the early 1970's by decreeing that the US dollar would no longer be gold backed. It is simply now backed by the economic might of the USA. "In God we Trust" has never been more literal. Money only has value because somebody else is willing to accept it for goods or services provided. By definition, this money is called "fiat currency", since its value is only based upon a declaration that it should be accepted for payment. Again, there is nothing tangible backing it, there are no chickens. I am constantly surprised by how many people believe that gold still backs their money.
Going back to the concept of fractional reserve, banks can lend out more than they have on deposit. Let's say that a bank has $100 in deposits, it can lend out $1000 if the reserve is at 10%. If the person borrowing the money turns around and deposits it all back in the same bank, then the bank's deposits have grown to $1100 and now they can loan out $11000. This money just gets created out of thin air. By controlling interest rates, the central banks can control the demand for money, and thus control the supply of more money. Low interest rates encourage people to borrow. Borrowing creates more money, and thus aids in liquidity. When borrowing gets greatly curtailed, as is happening now with the subprime crisis in the US, the money supply takes a hit, and liquidity becomes a problem. The central bankers in the US, namely the Federal Reserve, are lowering interest rates in an attempt to entice people to borrow money, thus getting more into circulation to deal with the liquidity crisis. Fractional reserve is kind of a necessary evil, due to charging interest on money. Paying interest means that the money supply has to grow somehow, else there won't be enough in circulation to make paying interest possible. There would be a major liquidity crisis.
Inflation really is simply the growth in the money supply. When lots of people are borrowing money, as happened when the baby boomers were borrowing money to finance their homes in the late 70s and early 80s, inflation goes up and the central bank raises interest rates to try to contain it.
I'll end this post with the comment that historically fiat currencies fail because they get abused by the people in power, past the point of no return. This type of money is also extremely vulnerable to a crisis in confidence, since nothing really backs it. Let's hope that the world banking system has learned from the past and survives this latest liquidity crisis.