First let’s determine what money actually is? Before the development of a medium of exchange – i.e., 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.
This early form of barter, however, does not provide the transferability and divisibility that makes trading efficient. For instance, if you have cows but need bananas, you must find someone who not only has bananas but also the desire for meat. What if you find someone who has the need for meat but no bananas and can only offer you chickens? To get your meat, he or she must find someone who has bananas and wants chickens...and so on.
The lack of transferability of bartering for goods, as you can see, is tiring, confusing and inefficient. But that is not where the problems end. Even if you find someone with whom to trade meat for bananas, you may not think a bunch of them is worth a whole cow. You would then have to devise a way to divide your cow (a messy business) and determine how many bananas you are willing to take for certain parts of your cow.
To solve these problems came commodity money: a type of good that functions as currency. In the 17th and early 18th centuries, for example, American colonialists used beaver pelts and dried corn in transactions; possessing generally accepted values, these commodities were used to buy and sell other things. The kinds of commodities used for trade had certain characteristics: They were widely desired and therefore valuable, but they were also durable, portable and easily storable.
What About Gold?
Another, more advanced example of commodity money is a precious metal like gold – which for centuries was used to back paper currency up until the 1970s. In the case of the American 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, 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 – after all, you can't eat it, 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 you can safely believe has worth. Gold therefore serves as a physical token of wealth, based on people's perception.
If we think about this relationship between money and gold, we can gain some insight into how money gains its value – as a representation of something valuable.