How Money Works?

There is one thing we absolutely cannot do without in our daily lives—money. Whether we want to travel, buy something, or give a gift, we need money. But have we ever thought about how money actually works? Or why it’s so universally accepted? In today’s article, we will explore specific aspects of money—what it is, its functions, types, and its effects during inflation and deflation.

In economics, anything that we use to buy and sell goods or services, or to lend and borrow, is considered money. It enables us to conduct transactions quickly and at minimal cost. Compared to the barter system, using money is far easier because there was no standard unit of value in bartering. But now, money allows us to determine the value of any good or service easily, minimizing or eliminating value loss in transactions.

The use of money began with trading valuable goods. Over time, the concept evolved into government-issued currency, digital money, and cryptocurrencies.

Money is a form of liquid asset used in exchange for value. Hence, it acts as a medium of exchange, store of value, and unit of account—these are its three main functions.

In the barter system, people exchanged goods directly. This only worked if both parties had something the other needed. Without mutual need, transactions became difficult. The invention of money solved this problem, allowing it to act as an intermediary in transactions—its most vital role today. But it serves additional functions:

Unit of Account

Since we now use money in all transactions, it serves as the unit of account. That means we determine the value of goods and services using money. For example, if you want to buy one kilogram of sugar, the shopkeeper may ask for 70 taka. This amount expresses the value of the sugar.

Store of Value

Money retains value over time, allowing us to save it and use it in the future. This characteristic is what gives money its universality. Without it, people wouldn’t accept money in exchange for goods or services.

Medium of Exchange

The main function of money is to act as an intermediary in the buying and selling of goods and services.

To be used as money, an item must fulfill several conditions. These include:

Uniformity

All units of money must look the same and carry the same value. For example, if you have a gold coin, it must be identical in size and value to other gold coins to be easily exchangeable.

Durability

Money must be able to withstand multiple transactions. If it wears out quickly, it loses its usefulness. That’s why perishable items are no longer used as money.

Portability

Money must be easy to transport. Items that are hard to move increase transaction costs. This is why metallic coins lost popularity over time and paper money became more common.

Recognizability

Money must be accepted and recognized by the public and the government. Without recognition, it cannot be used in broader transactions, increasing costs and reducing usability.

Stability

The supply and value of money must be stable. If the value fluctuates too much, it increases transaction risks and costs.

Although money can be classified in many ways based on its utility, today we generally see three main types:

Physical Money

This refers to banknotes and coins, which can be seen and touched. They are still widely accepted worldwide, though their usage is declining as the world modernizes.

Digital Money

With the rise of technology, digital money is becoming increasingly accepted. This includes money stored in bank accounts or mobile financial services. It enables online transactions without the need for physical presence.

Cryptocurrency

The newest addition to the world of money includes cryptocurrencies like Bitcoin and Ethereum. These decentralized digital currencies use cryptography for secure and efficient transactions. While they are not yet universally accepted, their popularity is growing as people become more concerned about financial privacy.

Money creation begins when the central bank (e.g., Bangladesh Bank) issues new currency notes. However, that’s just the start. In practice, commercial banks play a major role in creating money in the economy.

When we deposit money in a bank, the bank doesn’t keep all of it. It retains a portion and lends out the rest. This is called fractional reserve banking. For instance, if you deposit 100 taka, the bank might keep only 20 taka and lend out the remaining 80 taka. Through this system, banks create new money in the form of loans.

But this system also carries risk. If many depositors try to withdraw their money at once, the bank may not have enough reserves to fulfill the demand—a situation known as a bank run.

Over time, due to various factors, the prices of goods and services rise—this is called inflation. It typically occurs for two reasons:

• Excess demand
• Increased production costs

In both cases, purchasing power declines rapidly, and money loses value.

Deflation, on the other hand, is when the prices of goods and services fall. Though it may seem beneficial, it can significantly reduce economic activity and raise unemployment.

Inflation erodes purchasing power, meaning the same amount of money buys less than before. Savings and income also lose value. On the other hand, deflation can hurt businesses and economic growth. Therefore, maintaining a balance between inflation and deflation is crucial.

There’s not much ordinary people can do to control inflation—that’s the job of the central bank. Through monetary policy, central banks adjust interest rates and regulate money supply to maintain economic stability.

Understanding how money works is one of the most important parts of financial education. In today’s complex financial world, informed decisions require a solid understanding of money’s functions, features, and types. Hopefully, this article gave you valuable insights into the working of money, its evolution, and its impact on the economy.