Why money has value

One of the defining features of money is that it carries value. But who determines that value? This answer has shifted throughout history.

28 min

Quiz

Now that you understand some important ideas behind the concept of money, let’s dive into what it’s worth – and why that answer isn’t always the same. Who actually decides the value of money anyway?

Weight as value

As you learned in the previous lesson, the value of money is based on an agreement. People need to agree that a certain amount of money represents a certain amount of goods or services. In the beginning, these agreements were usually held up by a physical measure of value.

Take coins, for example. In the past, coins were made from precious metals such as gold, silver, or copper. Their value was directly linked to the amount of precious metal they contained. To know how much a coin was worth, you could simply weigh it — assuming the metal was of good quality.

Weight as value

The gold standard

Today, coins are no longer made from precious metals. The paper used for banknotes has little value on its own. The same is true for electronic money – the numbers you see in your bank account. So why do we all agree that money still has value?

For a long time, money was linked to gold. Each coin or banknote represented a fixed amount of gold or silver stored in secure vaults. This link to physical reserves is what gave money its underlying value.

Did you know?

The first known form of paper money dates back to 7th-century China. Merchants sometimes had to pay large sums to the wholesalers they bought goods from. Instead of carrying heavy bags of copper coins, they used written orders. These documents stated that the holder was entitled to receive a specific amount of coin money.

Market value and purchasing power

Today, the value of money is no longer anchored to gold or silver. Modern money has value because governments support it, central banks manage its supply, and it is accepted as payment in everyday life. Its value is determined by supply and demand on the currency market, where different currencies are traded.

If there is high demand for the euro, its value rises. If demand falls, its value goes down.

The value of money is also shaped by purchasing power. The more you can buy with a certain amount of money, the stronger its purchasing power — and the more that money is worth.

Key concept

What is market value?

Market value is the price something can be sold for at a specific moment. It is based on what people are willing to pay for it at a certain moment in time.

The role of central banks

It is important that the value of money remains stable. Otherwise, prices could change dramatically from one day to the next — groceries that cost €20 today might cost €500 tomorrow.

What is a central bank?

A central bank is a public institution responsible for managing a country’s money and financial system. It has the authority to take action when needed – for example by adjusting interest rates or influencing how much money is in circulation – to keep the value of money stable and support a healthy economy.

Examples of central banks

The European Central Bank manages monetary policy for the countries that use the euro.
The Federal Reserve is the central bank of the United States.
The Bank of England fulfils this role in the United Kingdom.

In order to prevent this from happening, countries and regions assign central banks the task of conducting monetary policy aimed at keeping the currency relatively stable. Through its monetary policy, the ECB (European Central Bank) aims to cap the price increases at 2% on a yearly basis over time, in order to help create confidence in the economy and society by keeping the value of money relatively stable. If people trust that money will keep its value over time, they are more willing to save, spend, and invest. When that trust weakens, money can lose value quickly.

History lesson

A ski resort, a French warship and the gold standard

After the Second World War, one US dollar was worth 0.03 ounces of gold for many years, thanks to an agreement between several countries. This agreement turned out to be unsustainable — much to the frustration of the French president at the time.

In 1944, representatives from 44 countries, including the Netherlands, met in the American ski resort of Bretton Woods. Their goal was to design a new global economic system for the post-war world — one that would prioritise stability.

Among other things, the countries agreed that the US dollar would become the currency of international trade. Countries trading with each other would use dollars. The dollar itself was linked to gold held in the vaults of the American central bank, the Federal Reserve. One ounce of gold (28.35 grams) was worth $35. That meant $1 always represented 0.03 ounces of gold — everywhere, all the time.

Cracks in the system
The Bretton Woods agreements led to a period of price stability after the Second World War. But over time, cracks began to appear. In the 1960s, the United States printed more and more paper money to cover rising costs, including those of the Vietnam War. This put increasing pressure on the promise that one ounce of gold was always worth $35.

Pompidou’s warship
Upon learning of this instability, certain countries naturally sought to exchange their US dollars for gold. The problem: the United States no longer had enough gold to do this. They had printed plenty more dollars, but had also been busy using those gold reserves. French president Georges Pompidou was not amused. He sent a warship to New York to reclaim the gold that France had stored in the United States.

The Nixon shock
In 1971, US president Richard Nixon decided to end the link between the dollar and gold. He announced this decision on television. From that moment — now known as the “Nixon shock” — there have effectively been no currencies whose value is tied to a precious metal.

Takeaways

What determines the value of money has changed over time
Nowadays, the value of money is determined by supply and demand
Central banks must ensure that the value of money remains stable

Test your knowledge

What does it mean when money is backed by physical reserves?

That coins and banknotes are valuable because they are hard to make

That money represents a fixed amount of gold or silver stored in vaults

That governments can print unlimited money without consequences

That money always keeps the same value over time

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