Historically, you could exchange banknotes issued by the Bank of England for gold. But the link between notes and gold was broken a long time ago, so nowadays it makes more sense to think of money as a kind of IOU (I owe you). The reason money works when you pay for things now is because people trust in its value. This guide explains this important link between money and trust.
Why does money depend on trust?
Imagine a world without money
To understand how money works, a good place to start is to think of a world without money.
In such a world, people could barter with one another: a fisherman could trade some of his catch for fruit grown by a farmer, say. Of course, this wouldn’t always be very convenient. For one thing, you wouldn’t always want to exchange goods at the same time as the person you’re trading with.
Using IOU notes could help with this. In the summer, when the farmer gives the fisherman berries, the fisherman could write the farmer an IOU. Later in the year, the fisherman could fulfil his promise by delivering some fish to the farmer.
While this could work on a small scale, in modern society people buy a huge range of different goods and services. If everyone relied on IOUs, it would soon become a very complex system. Because of the chains of IOUs involved, you might end up having to trust people you had never met before. Plus you’d need to trust that all the IOU notes you were receiving were genuine.
Simple example of exchange using IOUs
Complex web of IOUs
How does money make it easier to buy and sell things?
Because of these complications, using money is an easier and safer system for all involved. You can think of money as a special type of IOU: one that’s accepted by everyone.
When money is issued by a central bank, people are able to trust the value of the notes as they are all coming from a single, trusted source.
The Bank of England – the UK’s central bank – has been issuing banknotes for over 300 years. It’s our job to make sure that when you spend a banknote, the person who receives it can trust in its value – that they too will be able to exchange it for the same value of goods or services.
An important part of our work is therefore to make sure that the banknotes we all use have state-of-the-art security features, since if counterfeit banknotes are mistaken for genuine ones, this would erode people’s trust in their value.
What else affects how much my money is worth?
For a £10 note to be worth £10, people need to trust that the note is genuine. But how much you can buy with it also matters. This is why price stability is important. For instance, if prices go up drastically in a short time, you can’t buy as much with your money – and it becomes difficult to predict how much your money is worth. In really extreme cases of ‘hyperinflation’, prices have gone up by many times each day. This happened in Zimbabwe in the 2000s and resulted in people simply refusing to use Zimbabwean banknotes.
Here at the Bank of England we have a responsibility to make sure that the value of your money stays broadly stable. As explained in other KnowledgeBank guides, we do this by adjusting interest rates in order to target a low and stable rate of inflation.
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