Money as a Medium of Exchange:

Before the development of a medium of exchange that is, money—people would barter to obtain the goods and services they needed. Two individuals, each possessing some goods the other wanted, would enter into an agreement to trade.

Early forms of bartering, however, do not provide the transferability and divisibility that makes trading efficient. For instance, if someone has cows but needs bananas, they must find someone who not only has bananas but also the desire for meat. What if that individual finds someone who has the need for meat but no bananas and can only offer potatoes? To get meat, that person must find someone who has bananas and wants potatoes, and so on.

The lack of transferability of bartering for goods is tiring, confusing, and inefficient. But that is not where the problems end; even if the person finds someone with whom to trade meat for bananas, they may not consider a bunch of bananas to be worth a whole cow. Such a trade requires coming to an agreement and devising a way to determine how many bananas are worth certain parts of the cow.

Commodity money solved these problems. Commodity money is a type of good that functions as currency. In the 17th and early 18th centuries, for example, American colonists used beaver pelts and dried corn in transactions.

 Possessing generally accepted values, these commodities were used to buy and sell other things. The commodities used for trade had certain characteristics: they were widely desired and, therefore, valuable, but they were also durable, portable, and easily stored.

Another, more advanced example of commodity money is a precious metal such as gold. For centuries, gold was used to back paper currency—up until the 1970s. In the case of the U.S. dollar, for example, this meant that foreign governments were able to take their dollars and exchange them at a specified rate for gold with the U.S. 

Federal Reserve. What's interesting is that, unlike the beaver pelts and dried corn (which can be used for clothing and food, respectively), gold is precious purely because people want it. It is not necessarily useful—you can't eat gold, and it won't keep you warm at night, but the majority of people think it is beautiful, and they know others think it is beautiful. So, gold is something that has worth. Gold, therefore, serves as a physical token of wealth based on people's perceptions.

This relationship between money and gold provides insight into how money gains its value—as a representation of something valuable.