Standardized form of money that is widely accepted as a medium of exchange in transactions and serves as a unit of account and store of value

Author: Aditya Murarka
Aditya Murarka
Aditya Murarka
Aditya Murarka is a proactive finance professional pursuing a Bachelor of Commerce (Hons) at St. Xavier's College, Kolkata. Aditya has excelled in financial management, clearing CFA Level-1, and securing accolades in Chartered Accountancy. His diverse professional experience spans private wealth management, strategy consulting, and live projects in sectors like customs, manufacturing, and food delivery. Aditya, was a Financial Research Analyst and Chief Editor at Wall Street Oasis, exhibits expertise in statistical analysis, data analytics, and valuation. His leadership roles in the Consulting Club of his college and TEDx showcase strong team management and strategic skills. Aditya is well-versed in regression analysis, portfolio management, and has technical proficiency in Python, MS PowerBI, and more. Aditya is a versatile professional with a solid foundation in finance, strategic consulting, and leadership.
Reviewed By: Kevin Henderson
Kevin Henderson
Kevin Henderson
Private Equity | Corporate Finance

Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.

Previously, he was an Associate in the Power, Energy, and Infrastructure Investment Banking group at Lazard in New York where he completed numerous M&A transactions and advised corporate clients on a range of financial and strategic issues. Kevin began his career in corporate finance roles at Enbridge Inc. in Canada. During his time at Enbridge Kevin worked across the finance function gaining experience in treasury, corporate planning, and investor relations.

Kevin holds an MBA from Harvard Business School, a Bachelor of Commerce Degree from Queen's University and is a CFA Charterholder.

Last Updated:October 5, 2023

What Is Currency?

Currency is a term that refers to the money used within a specific country or region, representing its purchasing power. In simpler terms, it's the form of money we use in a particular nation.

Every country needs a system to conduct trade within its borders and with other nations. Currency plays a crucial role in this process and is a fundamental component of the global economic system.

Before the concept of currency, people used to exchange goods directly in a system known as barter. However, as societies grew and became more complex, a standardized unit of value was needed to make trade more efficient and adaptable to various conditions and countries.

As a result, each country eventually introduced its own form of currency, and all trade and commerce within that nation were conducted using this currency.

As the world became more interconnected due to globalization, there arose a need for a global medium of exchange. The challenge was that not every nation could participate equally, and it would disproportionately benefit wealthier countries.

To address this issue, exchange rates were introduced. Exchange rates are essentially the values at which one currency can be exchanged for another. They helped resolve several problems:

Exchange rates resolved this issue. Exchange rates are essentially the values at which one currency can be exchanged for another. They helped resolve several problems:

  • Currency Fluctuations: Exchange rates allowed for adjustments in trading amounts to account for fluctuations in currency values.
  • Liquidity: They increased the liquidity of all currencies in the open market, making it easier for parties involved in trade to benefit.
  • Regulatory Compliance: Exchange rates simplified compliance with regulations such as tax laws and record-keeping for financial transactions.

A global market was set up to facilitate the exchange of all currencies in circulation worldwide, and every coin was given a particular value through which it would be exchanged with each other.

This is how international trade operates today. Economies exchange goods for foreign currencies,  usually the currency of the importing nation or a widely accepted global currency like the US Dollar (USD). The value of the currency exchanged is typically equivalent to the value of the goods being exported.

Key Takeaways

  • Currency serves as a standard for money and purchasing power parity, representing a nation's domestic capital value.
  • Global trade relies on currencies to facilitate commerce within and across borders, playing a vital role in the interconnected global economy.
  • Exchange rates solve issues like currency fluctuations, liquidity, and regulatory compliance in international trade.
  • Throughout history, currencies evolved from barter systems to national and digital forms, with advantages and challenges for each system.
  • Digital currencies, like cryptocurrencies, challenge traditional monetary systems, potentially reshaping the global financial landscape.

Origin of Currency

Almost every nation in this world has a currency they use for trade and commerce in their daily lives. Some common examples are: 

  • The US Dollar
  • The Japanese Yen
  • The Euro
  • The Indian Rupee 
  • The Chinese Yuan 
  • The Russian Ruble etc.

These are the national currencies of some of the biggest economies in the world. The value of each of these currencies is different and constantly changes in the free market.

It is an essential tool, and everyone should work to understand more about global trade and commerce.

The first known currency is believed to be used in Ancient Egypt in Mesopotamia. Rice grains were stored in temple shillings and were used as a medium of exchange, mainly for barter transactions.

Coins in metal pieces were used in India for trade and payments to merchants and the military. Copper was the first metal to be used in the form of coins; silver and gold eventually followed.

The rarity of the metal defined the value of the coin. For example, gold was relatively rare to find compared to copper and silver. Thus it was valued more than the other two. 

It also varied in different regions. For example, in Europe, where silver was abundant because of huge silver reserves, the value of silver was relatively lower.

Bank notes or paper money

The first paper notes resembling instruments were believed to be first used in Ancient China, after the development of their paper technology. They used them as banknotes and trade tools to facilitate exchange.

Banknotes were preferred over coins because coins back then were heavy and hard to carry around. Back then, technology was not advanced enough to have minted small and thin coins.

Paper notes were easy to carry and easy to hide. However, they had a few downsides.

  • Paper notes had no intrinsic value, so that they could be rejected anytime for payment back then. Moreover, there was no governing system for currencies and prices as we have nowadays.
  • Also, governments and rulers can print more into circulation anytime, creating inflationary situations. This causes the money that each individual holds to lose value over time. 

These paper notes took over large hefty coins and became the standard of payments all across the globe. After the governments worldwide somewhat stabilized, trust in fiat money increased manifold.

The gold standard

The gold standard was a system where the values of major currencies were pegged to the value of gold. For issuing new notes and coins, economies needed to keep a fraction of the printable amount as gold reserves in the treasury.

Accordingly, the more gold a nation had, its denominations would have been more vital. Because of this, governments began hoarding piles of gold in their treasury, which eventually led to a shortage of gold with high demand, which caused an increase in gold prices all over the world.

This also imposed many restrictions on printing new money for the government, so they disliked it. 

Additionally, many impoverished nations that had attained independence from colonizations were not in a state to follow the gold standard of the Bretton Woods agreement, so they did not become a part of this system, which made it less inclusive.

The US was the only economy running on the gold standard; no other country had adopted this into full force. 

When the US inflation started rising in the 1930s and the great depression hit the States, demand for cash grew multifold, and the gold standard prohibited the government from printing more money.

Because of this, the US government banned private holdings of gold and made it a licensed-only commodity. This removed the dollar's peg from gold, but in paper terms, everything remained the same.

In the 1940s, after the allied powers won, the US led the allied forces into the Bretton Woods Agreement, which would have pegged each of the allies' currencies to gold. The US was responsible for determining and controlling the exchange rate of gold to USD.

As time passed, gold reserves became harder to find, and world trade grew rapidly, outgrowing the cash in circulation; thus, people needed more money to facilitate global growth and found this pegging system unsustainable. 

The world economies gave up the Bretton Woods system after the US withdrew under President Nixon.

Advantages and Disadvantages of Gold Standard

Let us take a look at some of the advantages and disadvantages of gold standard:

Advantages of Gold Standard are:

  • It imposed restrictions on printing new money, so the government had to follow those restrictions and not print blind money into circulation as it does nowadays.
  • It stabilized exchange rates of currencies back then as coins used to move 3-4% at maximum in months, unlike now when they are trading at a difference of 3-4% intraday very frequently.
  • It also reduced the fear of demand-led inflation as currency had a substantial intrinsic value over the marginal utility of products.

Disadvantages of the Gold Standard are:

  • Not every country had the same access to gold reserves, making it very unfair to many countries with zero to no gold reserves.
  • It imposed hefty restrictions on the government to print more money into circulation, which reduced the ability of central banks to interfere and control economic instruments in a crisis.
  • Gold is limited in nature, and supply-side inflation in a growing economy could put immense inflationary pressures on the economy.

Digital currencies

Digital Currencies are an innovation in today's day and age. Since the vast crypto boom from 2008 to 2021, Central Banks worldwide have been on high alert.

They plan to release their digital currencies and impose heavy restrictions on existing decentralized coins.

Cryptocurrencies are decentralized systems of software designed to work on a blockchain technology that keeps a record of transactions made through the denominations in a decentralized database that is not accessible only to the people on that blockchain.

They are believed to be an innovation in how we make payments globally. Currently, they are used chiefly for speculation purposes but potentially have an extensive use going into the future with globalization on the rise.

Transactions made through crypto coins are hard to track as they are fully decentralized, and the governments and central banks have insignificant to no control over them. 

They can reduce the grip that central banks have over the money supply in the economy, which is why they are planning to introduce their coins in the future.

Some countries like El Salvador have made crypto their fiat currency. They have replaced all their national denominations with crypto, and they hope that the capital appreciation in the value of these instruments will help grow their economy at a rapid pace.

El Salvador is not the only one to move into this space. The Central African Republic is also a nation that has made crypto its legal tender.

Big economies in other parts of the world are currently experimenting and developing on this issue, and they are going ahead with this quite conservatively.

Countries like China have already started using their digital denominations, the "Digital Yuan." The US's Federal Reserve is also working on the Digital Dollar, which would be pegged to the actual world USD, according to a spokesman at the Fed.

Apart from all this, digital currencies will restructure a new world order and truly change the world as we know it now, consistently moving us toward a more interconnected world.

Currency Trading (Foreign Exchange)

Currencies need to be traded to facilitate international trade. One money needs to be liquid enough, so there is no loss or gain due to speculation during the work.

At the time of the gold standard and the Bretton woods system, the currencies were exchanged at a relative value to gold. This was also the ancient system of trade in India and South Asia, where they used silver instead of gold.

Today, all the currencies are traded concerning the global reserve currency or the US Dollar. But how did the US Dollar become a global reserve currency (GRC)?

The USD became a GRC under president Nixon when the US abandoned the Bretton Woods system. The US Government was the most significant institutional single holder of gold reserves anywhere in the world. The USD was believed and is still thought to be the most stable currency in the world.

Seeing the problems with pegging currencies to limited and highly undistributed commodities, many countries then pegged their money to the USD, which is how it became a GRC.

Hence today, every trade between two countries either involves payments in Dollar terms as it is highly liquified, or it is traded according to the value of other nations' currencies in terms of US Dollars.

For example, If two countries, namely Saudi Arabia and Germany, want to trade, they can either make payments in dollars or first have to convert both their currencies in terms of dollar value and then equate the value of that item into their domestic currencies.

After the trade, a nation trades off the other nation's currency obtained during the transaction and buys either its domestic or the USD. This is facilitated through the World Currency Exchange, where Governments and institutions constantly trade currencies in the open markets.

This is how the value of currencies is determined now, and according to the demand and the supply of these instruments, their value is determined by the open market.

Researched and authored by Aditya Murarka | LinkedIn

Reviewed and edited by Justin Prager-Shulga | LinkedIn

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