5.2: The Types of Money

Money can be classified into two types based on whether it has intrinsic value. These are commodity money and fiat money.

Commodity money functions as a medium of exchange and also holds intrinsic value. It serves as a medium of exchange while also being useful in other ways. Examples of commodity money that were used in the past are gold, cowrie shells, and feathers. However, this type of money is often associated with practical limitations. For instance, gold could be challenging to carry in large quantities.

In contrast, fiat money such as banknotes does not have intrinsic value. It holds no value in itself. The fiat money system relies on the public's trust in it, which is reinforced by government regulation. The key reason people accept fiat money is that it is declared legal tender by the government. This means it must be accepted as a valid form of payment for all debts, both public and private. As a result, it functions as a reliable medium of exchange and a store of value, despite having no use outside of its role in the economy.

An important benefit of fiat money lies in its flexibility. Unlike commodity money, which is limited by the physical availability of the resource it represents, fiat money can be managed by the central bank. This flexibility allows the supply of money to be adjusted in response to the needs of the economy.

Money can be classified based on whether it has intrinsic value or not.

Commodity money functions as a medium of exchange but also holds value due to its usefulness in other ways—this is referred to as intrinsic value.

For example, gold was once used as money. Even if gold wasn't used to buy things, it still held value. People valued it for other uses, like making jewelry.

However, commodity money like gold could be heavy, making it inconvenient to carry.

Fiat money, on the other hand, has no intrinsic value.

For example, the U.S. dollar notes have no value beyond the printed paper.

Then why does the public accept it as a means of payment and a store of value?

This is because the government decrees it as legal tender.

The U.S. dollar is marked, 'This note is legal tender for all debts, public and private.' This means that the currency must be accepted as legal payment for debts. Additionally, people believe the central bank will manage the money supply responsibly, which reinforces their confidence in accepting fiat money.

One significant advantage of fiat money is that the central bank can expand or contract its supply to suit prevailing economic conditions.