How Money Works in Our Economic system-1
Definition of Money & Paper Money
Before we try to understand how Money works in a system, let’s first understand what Money stands for. Money’s core function is to work as a Means of Payment.
This core function of money makes ‘Transaction’ between two parties possible, in which one party may have goods and the other party ‘Money’. This imparts Money the ‘Purchasing Power’ and thus general acceptability in the system as a means for effecting transactions. For transactions to be effected in terms of Money, its important that the true value of the good can be measured in terms of money. This makes Money a ‘Unit of Measurement’ in the system.Interesting point here is that though Money works as a Unit of Measurement, its own value keeps fluctuating.
Money also makes it possible for us to de-link payment from actual transaction (This allows Credit system to work). However, since value of Money itself fluctuates, one needs to be compensated (such compensation forms part of the interest rate and is combination of Time Value of Money & uncertainty premium) to adjust for the fluctuation.
Another important role Money plays in any economic system is that it allows people to save or store their wealth in the form of Money. The real value of the wealth stored in the form of Money, however, fluctuates.
How Money Evolved
Until relatively recently, gold and silver were the main currency people used. These, precious metals seemed to serve all three needs: a stable unit of account, a durable store of value, and a convenient medium of exchange.
However, instead of carrying the actual metal around and exchanging it for goods, people found it more convenient to deposit precious metals at banks and buy and sell using a note that claimed ownership of the gold or silver deposits. Eventually, the paper claim on the precious metal was delinked from the metal. When that link was broken, fiat money was born.
Fiat Money means that money is accepted as money because a government says that it’s legal tender, and the public has enough confidence and faith in the money’s ability to serve as a storage medium for purchasing power. A fiat system is based on a government’s mandate that the paper currency it prints is legal tender for making financial transactions. Legal tender means that the money is backed by the full faith and credit of the government that issues it. In other words, the government promises to be good for it.
At the end, it would be a good idea to watch this IMF video: