How Currency Works

Whether we pull out paper bills or swipe a credit card, most of the transactions we engage in daily use currency. Indeed, money is the lifeblood of economies around the world. Currency refers to paper money or coins that are in circulation. But currency is actually only a small piece of the monetary economy and just one consideration when looking at the total money supply.

Indeed, most money today exists as credit money or as electronic records stored in databases in banks or financial institutions. But still, the bread and butter of everyday transactions is currency, and that is what we will look more closely at here.

Key Takeaways

  • Currency is the physical money in an economy, comprising the coins and paper notes in circulation.
  • Currency makes up just a small amount of the overall money supply, much of which exists as credit money or electronic entries in financial ledgers.
  • While early currency derived its value from the content of precious metal inside of it, today's fiat money is backed entirely by social agreement and faith in the issuer.
  • For traders, currencies are the units of account of various nation states, whose exchange rates fluctuate between one another.

What Is Currency?

While it may seem obvious, since we all use it on almost a daily basis, the exact meaning of money can also be elusive and nuanced.

Imagine you make shoes for a living and need to buy bread to feed your family. You approach the baker and offer a pair of shoes for a specific number of loaves. But as it turns out, he doesn’t need shoes at the moment. You’re out of luck unless you can find another baker—one who happens to be short on footwear—nearby.

According to mainstream economics, money alleviates this problem. It provides a universal store of value that can be readily used by other members of society. That same baker might need a table instead of shoes. In general, transactions can happen at a much quicker pace because sellers have an easier time finding a buyer with whom they want to do business.

Most importantly, money has to be the unit of account, or numeraire, which is a fancy term for the unit that things are priced in within a society. In the U.S. that is the dollar. Once there is a unit of account, people can indeed exchange on credit without the use of physical money.

Currency is the physical paper notes and coins in circulation. By accepting the currency, a merchant can sell his or her goods and have a convenient way to pay their trading partners. There are other important benefits of currency too. The relatively small size of coins and dollar bills makes them easy to transport. Consider a corn grower who would have to load a cart with food every time he needed to buy something. Additionally, coins and paper have the advantage of lasting a long time, which is something that can’t be said for all commodities. A farmer who relies on direct trade, for example, may only have a few weeks before his assets spoil. With money, she can accumulate and store her wealth.

History's Various Forms of Currency 

Today, it’s natural to associate currency with coins or paper notes. However, currency has taken a number of different forms throughout history. In many early societies, certain commodities became a standard method of payment. The Maya civilization often used cocoa beans instead of trading goods directly. However, commodities have clear drawbacks in this regard. Depending on their size, they can be hard to carry around from place to place. And in many cases, they have a limited shelf life.

These are some of the reasons why minted currency was an important innovation. As far back as the 3rd millennium B.C., Egyptians created metal rings they used as money, and actual coins have been around since at least 500 B.C. when they were used by a society in what is modern-day Turkey. Paper money didn’t come about until 806 A.D. in the Tang Dynasty in China. Metallic money in the form of coins made from precious metals such as gold, silver, or copper have been commonplace since early civilization.

Other forms of currency that have existed include large circular stone in the Pacific Islands, cowrie shells in pre-modern America, tobacco leaves, measurements of grains or of salt, or even cigarettes and packages of ramen noodles in prisons.

More recently, technology has enabled an entirely different form of payment: electronic currency. Using a telegraph network, Western Union (NYSE:WU) completed the first electronic money transfer way back in 1871. With the advent of mainframe computers, it became possible for banks to debit or credit each others’ accounts without the hassle of physically moving large sums of cash. 

Today, electronic payments and digital money is not only common, but has become the most important and ubiquitous money form.

Value in Currency

So, what exactly gives our modern forms of currency—whether it’s an American dollar or a Japanese yen—value? Unlike early coins made of precious metals, most of what’s minted today doesn’t have much intrinsic value. However, it retains its worth for one of two reasons.

First, in the case of “representative money,” each coin or note can be exchanged for a fixed amount of a commodity. The dollar fell into this category in the years following World War II, when central banks around the world could pay the U.S. government $35 for an ounce of gold. In other words, the paper money represented some claim on physical metal and could legally be redeemed for that metal on demand.

However, worries about a potential run on America’s gold supply led President Nixon to cancel this agreement with countries around the world. By leaving the gold standard, the dollar became what’s referred to as fiat money. In other words, it holds value simply because people have faith that other parties will accept it. Today, most of the major currencies around the world, including the euro, British pound and Japanese yen, fall into this category. Fiat money moreover derives its value from the trust in the government and its ability to levy and collect taxes.

Exchange-Rate Policies

While currency technically refers to physical money, financial markets refer to currencies as the units of account of national economies and the exchange rates that exist across currencies. Because of the global nature of trade, parties often need to acquire foreign currencies as well. Governments have two basic policy choices when it comes to managing this process. The first is to offer a fixed exchange rate.

Here, the government pegs its own currency to one of the major world currencies, such as the American dollar or the euro, and sets a firm exchange rate between the two denominations. To preserve the local exchange rate, the nation’s central bank either buys or sells the currency to which it is pegged.

The main goal of a fixed exchange rate is to create a sense of stability, especially when a nation's financial markets are less sophisticated than those in other parts of the world. Investors gain confidence by knowing the exact amount of the pegged currency they can acquire if they so desire.

However, fixed exchange rates have also played a part in numerous currency crises in recent history. This can happen, for instance, when the purchase of local currency by the central bank leads to its overvaluation.

The alternative to this system is letting the currency float. Instead of pre-determining the price of foreign currency, the market dictates what the cost will be. The United States is just one of the major economies that uses a floating exchange rate. In a floating system, the rules of supply and demand govern a foreign currency's price. Therefore, an increase in the amount of money will make the denomination cheaper for foreign investors. And an increase in demand will strengthen the currency (make it more expensive).

While a “strong” currency has positive connotations, there are drawbacks. Suppose the dollar gained value against the yen. Suddenly, Japanese businesses would have to pay more to acquire American-made goods, likely passing their costs on to consumers. This makes U.S. products less competitive in overseas markets.

The Impact of Inflation

Most of the major economies around the world now use fiat currencies. Since they’re not linked to any physical asset, governments have the freedom to print additional money in times of financial trouble. While this provides greater flexibility to address challenges, it also creates the opportunity to overspend.

The biggest hazard of printing too much money is hyperinflation. With more of the currency in circulation, each unit is worth less. While modest amounts of inflation are relatively harmless, uncontrolled devaluation can dramatically erode the purchasing power of consumers. If inflation reaches 5% annually, each individual’s savings, assuming it doesn’t accrue substantial interest, is worth 5% less than it was the previous year. Naturally, it becomes harder to maintain the same standard of living.

For this reason, central banks in developed countries usually try to keep inflation under control by indirectly taking money out of circulation when the currency loses too much value.

The Bottom Line

Regardless of the form it takes, all currency has the same basic goals. It helps encourage economic activity by increasing the market for various goods. And it enables consumers to store wealth and therefore address long-term needs. Currency was once limited to the domain of physical coins and bills, but today's digital economy means that money now exists as data stored in ledgers at banks, and is even transcending the possibility of tangibility with the development of cryptocurrencies such as Bitcoin which can never be made physical.

Article Sources
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