Microsoft Points have to be purchased either with a credit card on your Xbox 360 or you can buy points at retail locations. The math comes out to be that 80 Microsoft Points = $1. So, for example, a 400 point arcade game sets you back $5 in real money. You can buy points in a number of different allotments ranging from just a couple hundred all the way up to 5000 points at a time.
It isn't the greatest exchange rate, but it makes transactions in the Xbox Live Marketplace very easy and painless.