How Money Works

Money is something we use every day, but do we really understand how it works? It’s more than just paper bills or numbers in a bank account—it’s the foundation of modern economies. In this blog, we’ll break down the concept of money, how it functions, the different types of money, and how banks create more money.

What is Money?

Money is a tool that allows people to exchange goods and services efficiently. Before money existed, people used the barter system, where they would trade one good for another. However, bartering had several problems:

• It was difficult to find someone who needed exactly what you had to offer.

• It was hard to determine the value of one item compared to another.

• Storing perishable goods for trade was inconvenient.

To solve these problems, money was introduced as a universal medium of exchange that people agreed upon.

Functions of Money

Money is essential in an economy because it performs four key functions:

1. Medium of Exchange

Money allows people to buy and sell goods easily. Instead of trading a cow for wheat, you can simply use money to buy whatever you need.

2. Store of Value

Money can be saved and used later without losing its value. Unlike perishable goods (like fruits or milk), money remains useful over time.

3. Unit of Account

Money provides a standard way to measure the value of goods and services. For example, saying a laptop costs ₹50,000 makes it easy to compare prices and make financial decisions.

4. Standard of Deferred Payment

Money allows people to borrow and lend. If you take a loan today, you can pay it back later in the same unit of money rather than in goods or services.

Types of Money

Over time, money has evolved in various forms. Let’s look at the three main types:

1. Commodity Money

This was the earliest form of money where items like gold, silver, and even salt were used as a medium of exchange. These had intrinsic value because they were valuable on their own.

2. Fiat Money

Fiat money is the modern paper currency (like rupees or dollars) that has no intrinsic value but is valuable because the government declares it so. For example, a ₹500 note is just paper, but it has value because people trust the government behind it.

3. Digital Money

With advancements in technology, money has gone digital. Online transactions, credit/debit cards, and cryptocurrencies (like Bitcoin) have become popular, reducing the need for physical cash.

How Banks Multiply Money

Ever wondered how banks help create money? Here’s how:

1. You deposit ₹1,000 in a bank.

2. The bank doesn’t keep all of it; instead, it holds only a small portion (say 10%) and lends the rest (₹900) to another person.

3. That person spends the ₹900, and it eventually gets deposited in another bank.

4. This process repeats, creating more money in circulation than the actual physical cash available.

This system, called fractional reserve banking, helps economies grow but can also lead to financial crises if too much money is created irresponsibly.

Inflation & Deflation: The Impact of Money Supply

The amount of money in circulation affects the economy in two major ways:

1. Inflation (Too Much Money)

When there is too much money in the economy, prices rise because people have more money to spend. For example, if a chocolate bar costs ₹10 today and ₹12 next year, that’s inflation.

2. Deflation (Too Little Money)

When money supply decreases, prices drop. While this may sound good, it can actually hurt the economy because people delay spending, businesses make less profit, and jobs become scarce.

Conclusion

Money is much more than just currency—it’s a system that keeps economies running smoothly. By understanding how money works, you can make smarter financial decisions, manage your savings better, and even predict economic trends.

Want to learn more about finance? Keep following for more insights! 🚀