There are any number of explanations given as to where fairy beliefs came from. Some people have suggested that they were a race of small and less-aggressive people who lived in Europe and notably Britain before the Celts took over, and in order to survive they hid in the hills and forests. The fact that they are often depicted as wearing green or brown is taken to be further proof that they were trying to hide and blend in with their surroundings. People saw them and began attributing magical powers to them. The possibility that they were a "more primitive" tribe might also be a partial explanation for their fear of iron; if they had never learned to extract and use iron, it might seem especially powerful to them.
Others have put forth the idea that they were the gods worshipped by the Irish and Scottish before Christianity came and tried to wipe away all traces of any earlier religions.
Still other people yet believe that there are real magical beings (possibly from a different "plane", or that they are spirits and not phy sical) which account for the fairy belief. Whichever the real answer is, the fairy faith is dwindling (though you'd never know it from looking online.)
Another answer is that the stories of faeries started with a belief
that the dead have some sort of life after death. The fact that they live
in hills similar to burial mounds, or other places under the ground, has
contributed to this idea. In many faery stories, people who have recently
died are seen with the fae, and in some stories their partner is visited
by the spirit of a recently dead person, telling them how they can get
them back. If the partner complies perfectly, the person's spirit is
returned to their body.
In Brittany, according to Wentz (see bibliography), many of the same stories which are told about faeries in Britain, are told regarding ghosts.
It is worth noting that in many fairy tales, people who visit the land of the fae may only return if they haven't eaten the food or had anything to drink. This bears a close resemblance to the tale of Persephone, from Greek mythology, who was abducted by the god of the underworld (where the dead go), and had to spend six months of every year there because she ate six pommegranate seeds.
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