Question

Why do businesses accept paper currency when they know that, unlike a gold coin, the paper the currency is printed on is worth very little?

Short answer

Businesses accept paper currency despite its nominal value because it is a form of 'fiat money'. This means its value comes from its function as a medium of exchange, unit of account and store of value recognized by government. Its wider acceptance and functionality within the economic system also play key roles. The intrinsic value of paper money is less important than its accepted value in the market.

Step-by-step solution

Understanding Fiat Money

Fiat money refers to a currency that is issued by a government and is not backed by a physical commodity, like gold or silver. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. This is why, although the paper that the currency is printed on has minimal intrinsic value, it holds a value in the market.

Establishing Trust in the System

One of the most important features that fiat money provides is trust within the economy. Businesses accept paper currency as it is issued by the government, making it a legal tender. This designation means that the currency is recognized by the government as valid for payment of debts, which ensures acceptance of the currency by businesses.

Functionality in the Economic System

Paper currency serves as a medium of exchange that facilitates transactions. In order for a system of barter to work (i.e., trade goods or services directly for other goods or services), each party must have what the other wants. Money eliminates this problem by serving as a medium that is universally accepted in exchange for goods and services, allowing a greater range of trade and commerce.

Key concepts

Intrinsic Value

The concept of intrinsic value is a fundamental aspect of understanding why paper currency is so widely accepted despite its apparent lack of worth at first glance. Intrinsic value refers to the actual value of the materials that make up an object, in this case, the paper and ink used to make currency. In comparison, items like gold coins have an intrinsic value because the metal itself is precious and valuable.
However, fiat money, such as the paper currency issued by governments, does not derive its value from the materials used to create it. Instead, it gains value from collective belief and the trust people have in the economic system. This trust allows people to assign a value to currency based not on physical worth, but on the government's promise that it will be accepted in exchange for goods and services.

• This means that, even though the paper itself is worth intrinsically little, its perceived value is much greater due to the trust in the currency system.
• The acceptance of paper money exemplifies the power of perception over physical material worth in economics.

Understanding intrinsic value helps in realizing why people and businesses confidently use paper money in everyday transactions.

Legal Tender

Legal tender is a critical term in the world of economics and currency systems. It refers to any medium that must be accepted if offered in payment of a debt. In the case of fiat money, governments ensure its use and acceptance by designating it as legal tender.
This legal status means that individuals and businesses must accept it for transactions and debt payments. Its establishment is a way for governments to standardize currency acceptance across the economy. Without legal tender status, encouraging universal use of a particular form of money would be challenging, leading to confusion and inefficiencies in trade and the economy.

• Legal tender status promotes stability by ensuring everyone uses and accepts the same currency.
• It simplifies transactions, giving everyone the confidence to conduct business smoothly.

Thus, while paper currency might physically seem insignificant, its designation as legal tender is a backbone of modern financial systems.

Medium of Exchange

The medium of exchange is one of the essential roles that money plays in an economy. Simply put, it is an intermediary instrument that is used to facilitate the sale, purchase, or trading of goods between parties. Without a medium of exchange, each transaction would require direct bartering of goods and services, which can be inefficient and cumbersome.
By using money as a medium of exchange, people can overcome the "double coincidence of wants" problem inherent in barter systems—where one party must have exactly what the other wants at the time and place they want to trade. Money streamlines this process, providing a universally accepted method of exchange that can be readily converted to any other goods or services.

• It allows for more flexible, widespread trade, breaking the limitations found in direct bartering.
• Facilitating economic activity with ease, money as a medium of exchange is fundamental to the growth and functioning of economies.

Therefore, paper currency, though lacking intrinsic value, is pivotal due to its effectiveness as a medium of exchange in complex economic systems.