Money Bytes · Episode 1 · Money basics
What is money, really?
A $20 bill is just paper, so why does everyone take it? Money solves the problems of barter, and today's dollar is fiat money, backed by taxes, the law and trust instead of gold.
Before money: barter
Without money, people bartered: they swapped goods directly. The trouble is that a trade only works when each side wants exactly what the other has. A farmer with wheat who wants shoes has to find a shoemaker who happens to want wheat, right now, in the right amount. Economists call this the problem of the double coincidence of wants, and it makes trading slow and hard.
What money does
Money fixes that because everyone agrees to accept it. That lets it do three jobs:
- Swap (medium of exchange): sell your wheat for money, then spend the money on shoes. No one has to want your wheat except the buyer.
- Price (unit of account): every good gets a price in the same unit, so you can compare a loaf of bread with a pair of shoes at a glance.
- Save (store of value): money keeps for later, unlike wheat that can spoil.
Gold used to back it
For a long time, paper money in the United States could be swapped for gold or silver. That changed in the 1930s. Since January 30, 1934, Federal Reserve notes haven't been redeemable in gold for ordinary people. Foreign governments could still swap dollars for gold until 1971, when that link ended too.
Fiat money
Today's dollar is fiat money: money because the government says so, not because of a metal behind it. It's worth something for three main reasons:
- Taxes: the government accepts it for taxes, so everyone needs some.
- Legal tender: the law says it can pay debts.
- Trust: we accept it because we trust everyone else will accept it from us.
Canada works the same way: the Canadian dollar is fiat money issued by the Bank of Canada.
Try it yourself
Pull out any US bill and read the small print near the top: "This note is legal tender for all debts, public and private." Notice what it doesn't say: nothing about gold or silver.
Good to know
- Federal Reserve notes have not been redeemable in gold since January 30, 1934. Dollars stayed convertible to gold for foreign governments until 1971, and silver certificates could be redeemed for silver until 1968.
- Swap, price and save are the textbook functions of money: medium of exchange, unit of account and store of value.
- Why fiat money is accepted is simplified here to taxes, legal tender and trust; economists debate how much each one matters.
- Most money today is bank deposits, not paper bills.
- Educational only, not financial advice.
Test your knowledge
Quick quiz: What is money, really?
4 multiple-choice questions. Pick one answer for each, then check how you did.
Sources
- Federal Reserve Board, "Is U.S. currency still backed by gold?": Federal Reserve notes aren't redeemable in gold, silver or any other commodity; not in gold since January 30, 1934
- Federal Reserve Bank of St. Louis, "Here's Why the U.S. No Longer Follows a Gold Standard": off gold at home in 1933, international convertibility ended in 1971
- Federal Reserve Bank of St. Louis, "Functions of Money": medium of exchange, unit of account, store of value, and barter's problems
- Federal Reserve Bank of St. Louis, "How the Gold Standard Compares to a Fiat Money System": what fiat money is
Video transcript
A $20 bill is just paper. So why will anyone take it?
Before money, people bartered. A farmer with wheat who wanted shoes had to find a shoemaker who wanted wheat. That's hard.
Money fixes that. Everyone agrees to accept it, so you can swap anything for it, price everything in it, and save it for later.
Gold and silver used to back paper money. Not anymore. US dollars haven't been swappable for gold since the 1930s.
Today's dollar is fiat money. It's worth something because the government takes it for taxes, the law says it pays debts, and we all trust everyone else will take it.
That's your bite. Next: why your money buys less every year.