Currency is the lifeblood of economies all throughout the world, but it goes beyond coins and paper money. The majority of money in circulation today is credit money or electronic data kept in databases at banks or other financial institutions. However, currency continues to be a vital component of the monetary economy, and this article explores its significance to inflation as well as its history, varieties, and value.
In a Nutshell
- Transactions are accelerated and made more effective by the universal store of value provided by currency, which other members of society can utilize right away.
- Currency has existed throughout history in a variety of forms, including commodities, coins, paper money, and electronic money.
- The majority of contemporary currencies, including the U.S. dollar and the Japanese yen, are fiat money, meaning that people believe that other parties will accept them, giving them value.
- Governments have two options for controlling exchange rates: establishing a fixed exchange rate or allowing the currency to float. Each option has benefits and drawbacks.
- Hyperinflation, which reduces consumer purchasing power and makes it challenging to maintain the same level of living, can result from excessive money printing.
What is Currency?
Although it may seem obvious, as we all use it almost daily, the exact meaning of money can also be elusive and nuanced.
Imagine you make shoes for a living and you need to buy bread to feed your family. You approach the baker and offer him a pair of shoes for a certain number of loaves of bread. But it turns out that you don’t need shoes at the time. You’re out of luck, unless you find another baker nearby who is also short of shoes.
Money is a mechanism for exchanging time and effort.
Dave Ramsey
According to mainstream economics, money alleviates this problem. It provides a universal store of value that can be easily used by other members of society. That same baker might need a table instead of shoes. In general, transactions can take place at a much faster pace because it is easier for sellers to find a buyer with whom to do business.
More importantly, money has to be the unit of account, or numeraire, which is a fancy term for the unit in which things are priced within a society. In the United States it is the dollar. Once a unit of account exists, people can exchange on credit without using physical money.
Currency is the banknotes and coins in circulation. By accepting currency, a merchant can sell his products and have a convenient way to pay his business partners. Currency also has other important advantages. The relatively small size of coins and dollar bills makes them easy to transport.
Advertisement
Consider a corn farmer who would have to load a cart with food every time he needed to buy something. In addition, coins and paper have the advantage of lasting a long time, something that cannot be said of all commodities. A farmer who relies on direct trade, for example, can only have a few weeks before his goods spoil. With money, he can accumulate and store his wealth.
The Different Forms of Currency in History
Today, it is natural to associate currency with coins or paper bills. However, currency has taken various forms throughout history. In many early societies, certain commodities became a standard method of payment. The Mayan civilization often used cocoa beans instead of trading directly in commodities. However, commodities have clear disadvantages in this regard. Depending on their size, they can be difficult to transport from one place to another. And, in many cases, they have a limited shelf life.
These are some of the reasons why coinage was an important innovation. As early as the third millennium B.C., the Egyptians created metal rings that they used as money, and actual coins have been around since at least 500 B.C., when they were used by a society in present day Turkey. Paper money did not appear until 806 A.D. in the Tang dynasty of China. Metallic money in the form of coins made of precious metals such as gold, silver or copper has been common since the early days of civilization.
Other forms of currency that have existed are large circular stones in the Pacific Islands, cowrie shells in pre modern America, tobacco leaves, measures of grain or salt, or even cigarettes and packets of ramen noodles in prisons.
More recently, technology has made possible an entirely different form of payment: electronic currency. Using a telegraph network, Western Union (NYSE:WU) made the first electronic money transfer back in 1871. With the advent of mainframe computers, banks were able to debit or credit each other’s accounts without the hassle of physically moving large sums of cash.
Today, electronic payments and digital money are not only commonplace, but have become the most important and ubiquitous form of money.
Value in Foreign Currencies
So what exactly is it that gives value to our modern forms of currency, be it a U.S. dollar or a Japanese yen? Unlike early coins made from precious metals, most of what is minted today does not have much intrinsic value. However, it retains its value for two reasons.
First, in the case of “representative money,” each coin or bill 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, paper money represented some claim on physical metal and could be legally exchanged for that metal on demand.
However, concerns about a possible depletion of U.S. gold led President Nixon to cancel this agreement with countries around the world. By abandoning the gold standard, the dollar became what is known as fiat money. In other words, it has value simply because people have faith that other parties will accept it. Today, most of the world’s major currencies, including the euro, the British pound and the Japanese yen, fall into this category. In addition, fiat money derives its value from trust in government and its ability to impose and collect taxes.
Exchange Rate Policy
Although technically currency refers to physical money, financial markets refer to currencies as the units of account of national economies and the exchange rates that exist between currencies. Due to the global nature of trade, parties often need to purchase foreign currencies as well. Governments have two basic policy options when managing this process. The first is to offer a fixed exchange rate.
In this case, the government pegs its own currency to one of the major world currencies, such as the U.S. dollar or the euro, and fixes a firm exchange rate between the two denominations. To maintain the local exchange rate, the country’s central bank buys or sells the pegged currency.
The main purpose 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 purchase if they wish.
However, fixed exchange rates have also played a role in numerous currency crises in recent history. This can occur, for example, when the purchase of local currency by the central bank leads to its overvaluation.
The alternative to this system is to float the currency. Instead of predetermining the price of currencies, 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 the price of a foreign currency. Therefore, an increase in the quantity of money will make the denomination cheaper for foreign investors. And an increase in demand will strengthen the currency (make it more expensive).
Although a “strong” currency has positive connotations, there are downsides. Suppose the dollar were to gain value against the yen. Suddenly, Japanese companies would have to pay more to purchase U.S. made products, likely passing their costs on to consumers. This makes U.S. products less competitive in foreign markets.
The Impact of Inflation
Most of the world’s major economies currently use fiat currencies. Because they are not pegged to any physical asset, governments are free to print more money in times of financial distress. While this provides greater flexibility to meet challenges, it also creates the opportunity to overspend.
The greatest danger of printing too much money is hyperinflation. With more currency in circulation, each unit is worth less. Although modest amounts of inflation are relatively harmless, uncontrolled devaluation can drastically erode consumers’ purchasing power. If inflation reaches 5% per year, each individual’s savings, assuming they do not earn substantial interest, are worth 5% less than the previous year. Naturally, it becomes more difficult to maintain the same standard of living.
For this reason, central banks in developed countries usually try to keep inflation under control by indirectly withdrawing money from circulation when the currency loses too much value.
Wrap Up
In conclusion, money is essential for fostering economic growth and enabling customers to save wealth. Its significance hasn’t changed over time, despite the fact that its forms and value have.
FAQs
The term “currency” refers to coins or paper money that is currently in use and is used to exchange goods and services.
Throughout history, money has existed in a variety of forms, including commodities like cocoa beans, coins made of precious metals, paper money, and even electronic money.
Most modern coins do not have much intrinsic value, unlike early coins made of precious metals. It does, however, continue to hold value because people continue to trust the government and its capacity to levy and collect taxes.
The administration of currency exchange rates is referred to as exchange rate policy. Governments have two options: they can set a fixed exchange rate or they can let the currency float and let the market determine the price.
Over time, inflation may devalue a currency, decreasing its value. When a currency depreciates too much, central banks in wealthy nations frequently attempt to limit inflation by indirectly removing money from circulation.
Article sources
At Capital Maniacs, we are committed to providing accurate and reliable information on a wide range of financial topics. In order to achieve this, we rely on the use of primary sources and corroborated secondary sources to support the content of our articles.
Primary sources, such as financial statements and government reports, provide firsthand evidence of financial events and trends. By using primary sources, we are able to directly reference information provided by the organizations and individuals involved in these events.
Secondary sources, such as financial analysis and commentary, interpret and analyze primary sources. While these sources can be useful for providing context and background information, it is important to use corroborated sources in order to ensure the accuracy and reliability of the information we present.
We take pride in properly citing all of our sources, both primary and secondary, in order to give credit to the original authors and to allow our readers to verify the information for themselves. We appreciate your trust in our website and are committed to upholding the highest standards of financial journalism.
- Science – The Maya Civilization Used Chocolate as Money
- PBS.org, Nova Online – The History of Money
- Yale University – Silver, Small Data and Grand Narratives: Towards an (Integral) Agrarian History of Pharaonic Egypt (2500–550) BC
- Western Union – 6 Fascinating Things About Western Union’s History
- Office of the Historian – Milestones: 1969-1976: Nixon and the End of the Bretton Woods System, 1971–1973
