Money plays a central role in our lives, yet no one can be totally free of misconceptions about it. This article deals with only a few basic ideas, but it should help to gain an overall understanding of what money is and how it works.
Two Kinds of Money
Money is a token that is widely accepted as a medium of exchange. The token can be tangible like a coin or note, or intangible like a bank deposit. If the token is convertible on demand into a valuable commodity like gold, the token is known as commodity money.
The exchange value of commodity money varies, but is normally greater than its value as a commodity. A precious metal coin is simply a token potentially convertible into the bullion that comprises it.
If the tokens are intrinsically worthless and inconvertible, the government must endow them with a special status to make them viable as money. Such tokens are known as fiat money. Except for collector’s items, all government-issued tokens today are fiat money. One must therefore avoid thinking in terms of commodity money to understand modern money.
In the era of commodity money, the issuer was constrained by the need to hold a sufficient supply of the underlying commodity. There is no such constraint in the case of fiat money. The value of fiat money therefore depends on the policies and actions of the issuer, normally the central bank of a country.
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