In very simple economy, with very few goods, people can barter. However, when the economy grows, barter trade becomes ineffective. Let me explain this with a simple example. There was a small village by the river.
At first, there were only two families. One of them bred rabbits, and the other grew wheat. To diversify their diet, they traded with each other. They agreed that one bag of wheat will be exchangeable for one rabbit. After some time, other families began to settle in the village.
Every family produced something else. Some of them were producing clothes, other fished and still others bred cattle.
Over time, there were many goods and services.
A shoemaker sent his daughter Catherine to get a bag of wheat. The girl took the shoes and went to the farmer to propose a trade. The farmer agreed because he needed shoes and so they exchanged.
Next day, shoemaker, sent Catherine again to get one bag of wheat. But this time farmer replied: “I’m sorry, I don’t need a second pair of shoes, but I will give you wheat for a box of apples”.
So Catherine went to the gardener and proposed to exchange the shoes for some apples. The gardener replied: “I never wear shoes in the summer, I won’t be needing them for at least six months, I can give you apples in exchange for new horseshoes for my horse, though.”
So the girl went to the forge, but the blacksmith said, that he will give her horseshoes only for a new pair of trousers. Finally, the local seamstress agreed to exchange shoes for trousers. Unfortunately, this wasn’t the end.
It took Catherine half a day to find someone who needed shoes. Additionally, it took another half a day to finally get the wheat that she wanted. It’s a little hard to do shopping this way, isn’t it? Barter trade is ineffective and time-consuming.
People need something that can be used as a medium of exchange. Something everyone can accept. They needed money.
Money has specific properties.
Money is a medium of exchange, which allows us to avoid the problems that Catherine had. It’s also a unit of account, and can be used as a measure of costs and revenues through market prices.
Here’s some characteristics of money that allow it to be used that way:
1) It’s durable.
Money should last a long time without breaking.
2) It’s homogeneous.
This means that each unit should be identical.
3) Money is Portable,
so that it’s small enough that you can carry it with you.
4) Cash is Divisible,
so you can make change.
5) importantly, money should maintain its value over a long period of time,
so your saving would be worth the same even after many years.
Throughout human history, there have been many mediums of exchange. For instance, cattle, salt or seashells. None of them lasted very long as money.
Cattle, for example wasn’t divisible, interchangeable or easily portable. It also didn’t maintain its value over the long period of time. Salt becomes stale over time, so it loses value and it wasn’t homogeneous. This is because one bag of salt could be better quality than another.
However, one thing did emerge that had these qualities: gold and precious metals, which can be minted into coins or bars.
Gold can be a medium of exchange and a unit of account. We can count up the gold coins something costs. It’s durable, because it doesn’t corrode and it can last a thousand years. It’s homogeneous, because all one-ounce coins are identical and can be marked for purity. Coins are portable too, so a lot of purchasing power can fit in one’s pocket. It’s divisible, because coins can have different weights. And what’s most important, gold has been a very stable store of value, because it’s quantity is limited by nature.
Only a small amount of gold is mined each year in comparison to the quantity already in circulation. Because of these properties of gold, it has served as money for most of human history.
In modern times however, the whole world has abandoned the gold standard. You can read about the consequences of that here.