The purpose of this lesson is to give you a better understanding of what money is, where it derives its value, and what causes changes in the value of money.

We all use money on a daily basis to purchase necessities and maintain our lifestyle. It is generally defined as a store of value, a measure of purchasing power, and a medium of exchange for goods and services. Exactly what does this mean? Allow us to explain.

Money has value, which you can use to buy a certain amount of things.

The reason money has value is not because the pieces of paper money is printed on are worth anything… they’re practically worthless.

It is also not because it is representative of, or exchangeable for, a fixed amount of gold or some other commodity… it hasn’t been since 1971.

Paper money not backed by anything, or “fiat” money as it is referred to, has value because:

1) The government declares it legal tender and proclaims that it has value
2) The general population agrees that it has value
3) The general population agrees to accept it as a form of payment and medium of exchange

The value of money, like the value of most things, is determined by the laws of supply and demand. This basically means that the more money is out there, relative to the amount of goods and services available for purchase, the less value it has. Likewise, the less money is out there, relative to the amount of goods and services, the more value money has.

When there is too much money chasing too few goods, the goods become more expensive. This is called inflation, and it is measured as a percent called the inflation rate.

When there is a slowdown in the inflation rate, it is called disinflation. Disinflation means prices are rising, but not as quickly as they rise during an inflationary period.

When the inflation rate is negative, it means the prices of goods and services are falling and money is gaining value. This is known as deflation.

As we will explain in The Monetary System, the government is able to control the value of money to some extent, and this allows them to steer the economy clear of dangerous levels of inflation or deflation.

So now that you have a basic understanding of what money is and how it gets its value, you’re ready to learn about where it comes from and why more is printed. Continue to The Monetary System.

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