What exactly does it mean to be made in the image of God? The word "image" has overtones of "likeness" or "similar." In what way is man similar to God? Man is similar to God in that he is a moral creature. Man certainly doesn't share any of God's divine attributes. Even our moral likeness is imperfect. Finite. Mankind still possess the same moral similarity, although it is mortally wounded by sin. Our morality cannot be repaired, it needs to be remade; and that's exactly what Christ does for all who believe.
A moral creature is one who understands between good and evil and can choose between them.
Deu 1:39 Moreover your little ones, which ye said should be a prey, and your children, which in that day had no knowledge between good and evil, they shall go in thither, and unto them will I give it, and they shall possess it.
God himself shows that little children have no knowledge between good and evil. God did not hold these children responsible for their parent's sin, but allowed them to enter the Promised Land. All the parents died in the wilderness for their unbelief when they sinned.
Isa 7:16 For before the child shall know to refuse the evil, and choose the good, the land that thou abhorrest shall be forsaken of both her kings.
This verse also shows little children do not know between good and evil at first. This verse also shows that man has the ability to refuse evil and choose good.
Now, this is little speculation on my part, but when Adam and Eve sinned, God said "Behold, the man is become as one of us, to KNOW good and evil" (Gen 3:22). This knowledge is not evil, for God himself has this knowledge.
This is what happened when Adam and Eve sinned, now all men are born with the innate ability to know good and evil. Little children are born with this ability, but it is not developed and matured for some time. All children mature differently, but I would guess that no child truly understands between good and evil until he is maybe 7-8 years old. Only God knows when the individual has reached this maturity.
This knowledge makes man both responsible and accountable. A small child is not held accountable until he understands good and evil. The moment he does understand he becomes accountable and is condemned by the law when he sins. I believe this is what Paul was speaking of in Romans 7.
Rom 7:7 What shall we say then? Is the law sin? God forbid. Nay, I had not known sin, but by the law: for I had not known lust, except the law had said, Thou shalt not covet.
8 But sin, taking occasion by the commandment, wrought in me all manner of concupiscence. For without the law sin was dead.
9 For I was alive without the law once: but when the commandment came, sin revived, and I died.
10 And the commandment, which was ordained to life, I found to be unto death.
11 For sin, taking occasion by the commandment, deceived me, and by it slew me.
Paul here said he was alive without the law once. If a man is born dead in sin as many teach, then it could never be said a man was alive, but Paul clearly said he was alive. It was the law that taught him what sin is. Once he matured and understood the commandments, he was convicted by the law, he spiritually died. The law is good, but sin by the law convicted him and slew him.
Man is a moral creature because he understands right from wrong. The scriptures also show man has choice, he can refuse the evil and choose the good if he so desires.
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