How Does Money Work?


Quick Answer

Money is a universal medium of exchange that provides an easily convertible form of purchasing power for use in transactions. Money serves as a substitute for real goods and eliminates many of the inefficiencies of barter economies.

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Full Answer

Notes of currency are effectively IOUs that are issued by a trusted authority, usually a government or central bank. The notes promise to be exchangeable for their face value in goods, services and the payment of debts. If the issuing authority is perceived to be solvent and trustworthy, the notes it issues may be used in place of tangible goods for exchange throughout the economy.

Unlike the real goods exchanged in a barter economy, money is always accepted by sellers, which obviates the need to find the exact commodity a merchant wants in exchange for goods. Money thus permits a dramatic acceleration of the pace of economic transactions and an expansion of the available purchasing power in an economy.

The supply of money can also be expanded or contracted at the discretion of the issuing body to accelerate or slow the rate of economic growth, which permits a fine-tuned control over factors such as inflation, interest rates and unemployment. Some currencies, such as the U.S. dollar, also act as a reserve commodity in themselves, protecting economies from fluctuations in the price of commodities such as oil.

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