When people exchange goods and services without using money, this is called barter. "I'll cook dinner if you'll do the dishes" is an example of barter.
Imagine an economy in which I can sell services as a consultant to banks, but what I want is to buy a new suit. The clothing store that sells suits does not have any use for my services as a banking consultant. The bank does not sell suits. How can barter work?
One can imagine a computer system that finds a bank that wants my consulting services, a clothing store that needs banking services, and then arranges a three-way trade where I get my suit in exchange for consulting services. As the economy gets more complex, the computer system has to arrange barter trades that are more and more elaborate.
Instead of a computerized bartering system, we use money to implement complex exchanges. I sell consulting services for money, and I buy a suit using money. Money serves as a medium of exchange.
Using money, my exchange of consulting services for a new suit is not simultaneous. The transactions take place at different points in time. For this to work, money must hold its value over time. Thus, money also acts as a store of value. I can hold onto money for a few days without having it lose value.
When money is established as a medium of exchange, people get used to calculating value in terms of money. Thus, money becomes a unit of account. Using money as a unit of account breaks down if we are doing cross-country comparisons. A Canadian dollar and a U.S. dollar are not the same.
Commodity Money and Fiat MoneyCommodity money consists of objects that have value but which are used as a medium of exchange. Pretty shells could serve as commodity money. Gold jewelry can serve as commodity money. Among prisoners, cigarettes often serve as commodity money.
As a practical matter, money is anything that is widely accepted in exchange. With commodity money, people will want to hold onto valuable samples and to use the least valuable samples for payment. Thus, among prisoners, the least popular cigarettes will end up being used as currency. This tendency for the least valuable currency to circulate is known as Gresham's Law.
Fiat money is something that has no intrinsic value, but which the government declares by fiat to be money. If you look at a dollar bill, you will see the phrase "legal tender for all debts, public and private." What that means is that if someone sells you something and you "tender" the currency (offer the currency as payment), you have legally paid, whether or not the seller accepts your currency. By making U.S. currency legal tender in this country, the government forces people to accept it as a medium of exchange.
With the concept of fiat money, the government can turn worthless pieces of paper into something of value. The reason that people value money is that it allows for complex exchanges to take place more easily than using barter.
The difference between the value of goods and services that a dollar can buy and the cost of printing the dollar represents a profit to the government, or a form of taxation. This tax is called seignorage.
Surviving The Global Depression - Soviet Style 1 of 2
Surviving The Global Depression - Soviet Style 2 of 2