What is Money?

We all use money every day without really thinking about it. Money is one of the most important things in our lives. Therefore it is surprising how little most people know about it. Money is far more complicated than just the bills in your pocket, in fact there is no universally agreed on definition of what qualifies as money. Understanding what money is and why it has value is important if you are going to be using money. It will help you to make sense out of the way economic decisions are made.

Money is simply a medium of exchange; it is something that has value that can be exchanged for another thing that has value. In most cases money is bills or coins but it can actually be anything and over the course of history a great variety of items have been used as money. Money was created to solve the problems that barter created. In the early days people would trade a product or a service for a different product or service. This worked fine until you started to run into situations where you needed something but what you had to offer in return wasn’t what the other person wanted. This ended up resulting in complicated trades involving multiple parties so that everybody could get what they wanted. Eventually it was realized that things would be simpler if there was a medium of exchange that allowed people to make these transactions without involving all the other parties.

Through most of its history money has been commodity backed. That is it could be exchanged for a specific commodity at a specific price. The gold standard was the most well known of these. This had the advantage of helping to instill confidence in the currency since people knew that it could be traded for something they knew had value. The problem with commodity backed money is that it limits economic growth since the money supply can’t easily be increased. There is only so much gold available and if your money is backed by gold the amount of money available is going to be limited.

In order to get around this problem the decision was made by most countries to abandon commodity backed money and go with fiat money. This is money that has value because the government says it has value. Although this money isn’t backed by a specific commodity it is backed by the strength of a countries economy. The advantage is that the money supply can increase as economic output increases. However this doesn’t mean the government can just print money. If they did it would decrease in value since supply would exceed demand. The value of the currency is determined by the economic output of the country. As the output increases the demand for money increases. This allows the government to put more money into circulation without its losing value.