Why does money have value about.com

So, gold is something that has worth. Gold, therefore, serves as a physical token of wealth based on people's perceptions. This relationship between money and gold provides insight into how money gains its value—as a representation of something valuable.

The second type of money is fiat money , which does not require backing by a physical commodity. Instead, the value of fiat currencies is set by supply and demand and people's faith in its worth. Fiat money developed because gold was a scarce resource, and rapidly growing economies growing couldn't always mine enough to back their currency supply requirements. Fiat money becomes the token of people's perception of worth, the basis for why money is created.

An economy that is growing is apparently succeeding in producing other things that are valuable to itself and other economies. The stronger the economy, the stronger its money will be perceived and sought after and vice versa. However, people's perceptions must be supported by an economy that can produce the products and services that people want. For example, in , the U.

If the economy stalls, the value of the U. The implosion of the U. Today, the value of money not just the dollar, but most currencies is decided purely by its purchasing power , as dictated by inflation. That is why simply printing new money will not create wealth for a country. Money is created by a kind of a perpetual interaction between real, tangible things, our desire for them, and our abstract faith in what has value.

Money is valuable because we want it, but we want it only because it can get us a desired product or service.

But exactly how much money is out there, and what forms does it take? Economists and investors ask this question to determine whether there is inflation or deflation. Money is separated into three categories so that it is more discernible for measurement purposes:. By adding these three categories together, we arrive at a country's money supply or the total amount of money within an economy. The M1 category includes what's known as active money—the total value of coins and paper currency in circulation.

The amount of active money fluctuates seasonally, monthly, weekly, and daily. Treasury Department. Banks lend money out to customers, which becomes active money once it is actively circulated. The variable demand for cash equates to a constantly fluctuating active money total.

For example, people typically cash paychecks or withdraw from ATMs over the weekend, so there is more active cash on a Monday than on a Friday. The public demand for cash declines at certain times—following the December holiday season, for example. We have discussed why and how money, a representation of perceived value, is created in the economy, but another important factor concerning money and the economy is how a country's central bank the central bank in the United States is the Federal Reserve or the Fed can influence and manipulate the money supply.

If the Fed wants to increase the amount of money in circulation, perhaps to boost economic activity, the central bank can, of course, print it. However, the physical bills are only a small part of the money supply.

Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market. When the central bank buys these government securities, it puts money into the marketplace, and effectively into the hands of the public. How does a central bank such as the Fed pay for this? As strange as it sounds, the central bank simply creates the money and transfers it to those selling the securities. To shrink the money supply, perhaps to reduce inflation, the central bank does the opposite and sells government securities.

The money with which the buyer pays the central bank is essentially taken out of circulation. Keep in mind that we are generalizing in this example to keep things simple. A central bank cannot print money without end. If too much money is issued, the value of that currency will drop consistent with the law of supply and demand.

Remember, as long as people have faith in the currency, a central bank can issue more of it. But if the Fed issues too much money, the value will go down, as with anything that has a higher supply than demand. Therefore, the central bank cannot simply print money as it wants. In the 17th century, Great Britain was determined to keep control of both the American colonies and the natural resources they controlled.

To do this, the British limited the money supply and made it illegal for the colonies to mint coins of their own. Instead, the colonies were forced to trade using English bills of exchange that could only be redeemed for English goods.

Colonists were paid for their goods with these same bills, effectively cutting them off from trading with other countries. In response, the colonies regressed to a barter system using ammunition, tobacco, nails, pelts, and anything else that could be traded.

Colonists also gathered whatever foreign currencies they could, the most popular being the large, silver Spanish dollars. These were called pieces of eight because, when you had to make change, you pulled out your knife and hacked it into eight bits. From this, we have the expression "two bits," meaning a quarter of a dollar. Massachusetts was the first colony to defy the mother country. In , the state minted its own silver coins including the Oak Tree and Pine Tree shillings.

The state circumvented the British law stating that only the monarch of the British empire could issue coins by dating all their coins in , a period when there was no monarch. In , Massachusetts also issued the first paper money calling it bills of credit. Tensions between America and Britain continued to mount until the Revolutionary War broke out in The colonial leaders declared independence and created a new currency called Continentals to finance their side of the war.

Unfortunately, each government printed as much money as it needed without backing it to any standard or asset, so the Continentals experienced rapid inflation and became worthless. This experience discouraged the American government from using paper money for almost a century. The chaos from the Revolutionary War left the new nation's monetary system a complete wreck.

Also, the certificate was easier and safer to carry than the actual gold. Over time people grew to trust the paper certificates as much as the gold. Representative money led to the use of fiat money-the type used in modern economies today. Fiat money is money that does not have intrinsic value and does not represent an asset in a vault somewhere. Its value comes from being declared "legal tender"-an acceptable form of payment-by the government of the issuing country.

In this case, we accept the value of the money because the government says it has value and other people value it enough to accept it as payment. For example, I accept U. Because I know others will accept it, I am comfortable accepting it. It is not a commodity with its own great value and it does not represent gold-or any other valuable commodity-held in a vault somewhere. It is valued because it is legal tender and people have faith in its use as money.

There have been many forms of money in history, but some forms have worked better than others because they have characteristics that make them more useful. The characteristics of money are durability, portability, divisibility, uniformity, limited supply, and acceptability. Let's compare two examples of possible forms of money:. Well, it seems "udderly" clear at this point that—based on the characteristics of money—U.

To summarize, money has taken many forms through the ages, but money consistently has three functions: store of value, unit of account, and medium of exchange. Modern economies use fiat money-money that is neither a commodity nor represented or "backed" by a commodity. Even forms of money that share these function may be more or less useful based on the characteristics of money.

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Reviewed by Michael J Boyle. Article Reviewed May 21, Michael Boyle is an experienced financial professional with more than 10 years working with financial planning, derivatives, equities, fixed income, project management, and analytics. Learn about our Financial Review Board. When the demand for Treasurys is high, the value of the U.