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.

To understand why civilized societies have used currency throughout history, it’s useful to compare it to the alternative. 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.

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. By accepting currency, he can sell his goods and have a convenient way to pay the furniture maker. 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.

There are other important benefits of money 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. (For related reading, see: What Is Money?)

Today, it’s natural to associate currency with coins or paper notes. However, money has taken a number of different forms throughout history. In many early societies, certain commodities became a standard method of payment. The Aztecs 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 2500 B.C., Egyptians created metal rings they used as money, and actual coins have been around since at least 700 B.C., when they were used by a society in what is modern-day Turkey. Paper money didn’t come about until the Tang Dynasty in China, which lasted from A.D. 618-907.

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. 

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.

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.

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. (For related reading, see: Is all paper money fiat money?)

Today, most of the major currencies around the world, including the euro, British pound and Japanese yen, fall into this category.

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 a 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.

Most of the major economies around the world now use fiat currencies. Since they’re not linked to a 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 related reading, see: How Inflation Affects Your Cost 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.

Regardless of the form it takes, all money 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. (For related reading, see: What Factors Move a Currency?)