Currency, in economics, refers to a generally accepted form of money, which is basically a medium of exchange or an intermediary used in trade so as to avoid the inconveniences associated with barter system. Each country has its own currency in the shape of coins and banknotes, which is the physical aspect of a country’s money supply; bank deposits are the other part of money supply. Both physical currency and bank deposits can be used as legal tender as mediums of exchange for goods and services. While coins and paper money must be exchanged physically, bank deposits can be transferred by way of checks, debit cards or any other form of a negotiable or non-negotiable instrument.
Early humans did not buy goods from others with money. They used a barter system, a system of exchange of personal valued possessions for other goods. What led to the first proper money as a medium of exchange was when things like grain, precious metals and furs began being exchanged. Even till very late, in modern times also, the commodity nature of currency was retained and gold and silver were used as currency. However, currently almost all monetary systems in the world rely on fiat money, which is a declaration by the government that the coins and notes issued by the central bank of the country will be official medium of payment or legal tender. However, in modern economies like USA and Eurozone, the major part of money supply is in the form of electronic money.
History of Currency
The history of currency is basically the history of trade. As trade advanced, it became nearly impossible to use personal possessions such as livestock as a medium of exchange. Later, grain came to be used as money, which was primarily in the form of a receipt that represented grain stored in temples in what was then Ancient Egypt. Currency, as we know it now that is the use of metals as stored value became the medium of exchange for trade around 2000 BC and remained as such for almost 1500 years.
The breakdown of the trading system in the Near East revealed a flaw in the system: the value of a circulating currency was as secure and safe as the ability to defend it. If there was no place safe enough, trade could reach only up to a point where military could easily defend it. With passage of time, by the time the Bronze Age would be over, some international treaties were made to allow merchants to carry their goods safely in and around the Fertile Crescent; Mesopotamia, the land between the rivers Tigris and Euphrates, Eastern Mediterranean and Bahrain. The currency used by merchants in those days is not fully known but it is generally agreed by historians that copper ingots produced in Cyprus were the generally accepted medium of exchange. Rampant piracy marked the end of the Bronze Age and along with it this trading system. Prosperity returned as Phoenician trade recovered in the 9th and 10th centuries BC. This also marked the beginning of the era of real coinage.
Currency evolved differently in various civilizations. Many civilizations have used cowries as currency and as late as middle of the 19th century, cowries were still being used as money in some parts of Africa. Money in Africa evolved from beads, ivory, ingots, livestock, and different types of weapons, ochre and other earth oxides. Around 15th century, in West Africa rings made from Manila hemp were used as money for buying and selling slaves.
All this was enough reason for societies to shift to metal as stored value. Initially, it was silver and later it became silver and gold both. Bronze was also used at some point in time. Modern coins are made of copper and other non-precious metals. Metals coins were stamped and weighed so that the giver and receiver both knew that a coin represented value equivalent to a certain weight of a precious metal. Coins could be counterfeited. While this was one factor that led to banking, the Archimedes’ principle provided a tool that could be used to determine the value of a coin even if it had been tampered with in any way.
A three tier system of coinage was used by most economies with copper being at the bottom and used for common low value transactions. Silver and gold formed the next two tiers and were used for mid-sized and large purchases respectively. This monetary system was prevalent in Ancient India since early sixth century BCE and continued till the advent of paper money. The same system was prevalent in Europe and used till the end of the Middle Ages.
The first known paper money appeared in China in the ninth century. Factors that led to it were the need for credit and finding a medium of exchange that was less cumbersome than using thousands of coins for transacting business. Initially, it was in the form of receipts of deposits that wholesalers issued as promissory notes. These were valid for a small period and within a small region. Later, in the 10th Century, during the reign of Song Dynasty, the government began issuing promissory notes amongst traders in the salt industry, which was a government monopoly. At first, the right to issue these promissory notes was granted to several shops but later, towards early 12th century the government took over and started producing currency on its own.
However, these banknotes were still temporary in nature and for use in small regional territories. It was not until middle of 13th century that a standardized, uniform and nationally acceptable paper currency was issued by the government.
About the same time, 7th to 12th century, a strong monetary system also evolved in the Islamic world. Riding over a strong and stable currency, the dinar, Muslim economists, merchants and traders were able to innovate and introduce checks, promissory notes, credit and a variety of accounts including savings, loaning and transactional, banking and transfer of debt and credit.
Paper currency arrived in Europe only in the 17th century in Sweden (1661). Copper coins were commonly used as Sweden had huge copper resources. However, low value of copper necessitated big coins weighing several kilograms and difficult to transport. Paper currency was evidently much more convenient, not only because it was easy to carry but because of several other reasons as well. It reduced the risk associated with transportation of silver and gold and made easier the process of lending gold and silver on interest: the specie – gold or silver – remained with the lender till the time someone came to redeem the promissory note. However, the biggest advantage of paper currency was that it divided currency into two forms, credit and specie.
The advantages of paper currency were evident but the hidden disadvantages took time to reveal themselves. Specie always had intrinsic value, something that was not there in paper currency. Initially, authorities would print only as much paper as they had specie to back it. However, actually they could, if they wanted to, (either due to greed or need) print more than the gold or silver they had for backing it. Too much money supply meant there was more money to chase lesser goods, a phenomenon that causes inflationary pressures. Rampant inflation often results in people wanting hard money, which can reduce the demand for paper money to zero.
Paper currency also earned a bad name as it came to be associated with war financing and being a part of maintaining standing armies. Moreover, as it increased the potential of wealth creation and speculative profits, people started getting addicted to it. Still, most of the bigger nations founded mints for producing coins and print paper money and treasuries for holding stocks of gold and silver and collecting taxes.
Until this time, gold and silver both were still legal tender. The increase in supply of silver in the 19th century increased the instability in the ratio between the two, which led to bimetallism, a monetary standard under which the basic unit of currency is defined by stated amounts of two metals (gold and silver) with values set at a predetermined ratio. Currency could now be also used as a tool for policy; for example, the printing and direct circulation of the United States Greenback for funding military expenditure during the American Civil War. Redemption of paper currency for specie was no longer taken for granted as governments could set the rules as to how much of it and when it could be redeemed.
By the start of the 20th century, nearly the entire industrialized world was on a gold standard of some sort with silver coins and paper currency as the circulating currency. Banks worldwide, private as well as government followed the Gresham’s Law of backing paper currency with gold and silver. However, the gold standard could not stand the test of time and there were deviations from the rule in times of war and in financial crisis. Eventually, it led to the adoption of floating currencies backed only by a fiat stating that a certain known value shall be paid in exchange of a banknote.
Fiat Currency – Banknotes
Fiat currency refers to money whose value stems from a government regulation or law instead of something of intrinsic value, mostly gold or silver. Any money whose initial value is established by a government decree and declared by the government to be legal tender is fiat currency. The cash form of such money is cash and banknotes, mostly made of paper. However, Australia is credited with the world’s first polymer currency, developed by Commonwealth Scientific and Industrial Research Organization and introduced into circulation in 1988 on the country’s bicentenary. Polymer currency improves the life of banknotes and eliminates the risk of counterfeiting and is now in use in nearly 22 countries.
Every sovereign state chooses which currency it will use. Since there are more than one (actually dozens) currencies called the dollar or franc, the International Organization of Standardization has put in place a system of three-letter coding to remove the confusion. Even the name pound is used by several nations, all having different values. As a standard practice the first two letters refer to the country and the last to the name of the currency, for example, P for pound and D for dollar. GBP is thus Great Britain Pound and USD refers to the US dollar.
Production, Control and Monetary Policy
Generally, in almost all cases the central bank of a country has monopolistic control over currency production, control and monetary policy. Central banks determine the amount of coins and banknotes shall be released for circulation in the country or in some cases, group of countries. Central banks also use monetary policy as a tool to regulate credit, which is actually indirect production of money by banks.
Trade between two countries involves two separate currencies. Cross border trade between any two countries is facilitated through currency exchange rate, which is basically the price of one currency in terms of another. Exchange rate also determines the price at which goods and services of a country can be bought from or sold to another country.
The exchange rate between two currencies is determined by market forces and speculative demand. This applies only to currencies that follow a free floating exchange rate regime. The exchange rate of fixed currencies is pegged at a particular point and changes only if the government chooses to devalue or appreciate currency value.
However, the monetary authority, the authority that controls a country’s currency, derives its power from the present day government and the degree of autonomy it enjoys depends upon the government that creates it. The legislative or executive authority that delegates power of control to a monetary authority can reduce it through appropriate legislation/ executive order as the case may be. Some governments however choose to control currency through their Finance Ministries.
Some countries use the same name for their distinct currencies. For example, USA, Canada and Australia, to name a few, use the same name, dollar. There are also cases where the same currency is used by more than one country; the euro is legal tender throughout the European Union. There have been and still are, cases of countries declaring the currency of a foreign country to be legal tender in their country; the US dollar is legal tender in Panama and El Salvador. Similarly, the Spanish silver coins were acceptable medium of exchange in USA from 1791 to 1857. At times, countries have also re-stamped coins of a foreign country or used a country board, (monetary authority required for maintaining a fixed exchange rate) to issue one currency note for each currency note of a foreign country held. Ecuador is one country that currently follows this practice.
Typically, every currency has a primary unit of currency; dollar, euro or franc and a fractional unit. Some currencies, for example the Icelandic króna, no longer have a fractional unit. Historically, many countries used a non-decimal system for fractional units of currency. Not very long ago, the Pound equaled 20 shillings, which in turn equaled 240 pence. Presently, all currencies, barring two, use a decimal system, meaning thereby that the fractional unit is valued at 1/100 of the primary unit. 100 cents make a dollar, 100 pence make a pound and 100 centimes make a franc. The only two countries that do not use a decimal system for their currencies are Mauritania and Madagascar. However, their currencies have fallen into disuse due to unbridled inflation.
Convertibility of a currency refers to the ease with which an individual or business can convert home currency to another currency and the other way round. Ease of conversion refers to the restrictions placed by the central bank or government. Based on the level of restrictions, currencies may be classified as fully convertible, partially convertible or non-convertible.
Fully Convertible currencies are those currencies on which the government places no restriction whatsoever on the amount that can be traded in the currency market. Nor does the government or central bank enforce an artificially fixed or minimum value to it in international trade. The US dollar is a fully convertible currency, which is the reason why it has been the preferred currency for international trade since long and also among the most frequently traded currencies in the foreign exchange market.
Partially convertible currencies are those where the central bank controls flow of the home currency in and out of the country. While there are no restrictions on transactions relating to domestic trade and investments, international transactions require special approval from the central bank, which reserves the right not to sanction conversion into another currency. The Indian rupee (INR) is a partially convertible currency.
A non-convertible currency is the one that is not allowed to participate in the foreign exchange market and which cannot be converted into other currencies by individuals and businesses. These are basically blocked currencies and the North Korean Won and the Cuban Peso fall in this category.
A local currency is a currency that is used in a locality or a small area. If the area is large enough, it is termed as regional currency and community currency if its use is restricted to a community. Local currency is accepted as a medium of exchange within a specified area and is not supported by a national government and is not necessarily a legal tender.
Local currency provides extremely underdeveloped regions a chance to pull themselves up as it provides a medium of exchange that can be used for exchanging goods produced locally and services. Advocates of local currency opine that this was the original and the primary purpose of currency and useful for economically depressed societies within a country. Critics, on the other hand, are of the opinion that local currencies can be used as a means for evading tax and create barriers that can be detrimental to the country’s economy.
Sometimes local currencies spring up unknowingly when the national currency is facing extreme pressure due to a crisis. A recent example is that of the 2002 economic crisis in Argentina. IOUs issued by local governments to overcome fiscal problems came to be used as local currency.
Just as the countries that formed the European Union chose to use a new currency, the euro, as their currency, there are some proposed currencies that may (or may not) appear in the near or distant future. For example, a hypothetical American currency union proposes Amero to be the name of its currency if the union comes into being. Similarly, an Asian currency unit is proposed by the Asean+3, East African shilling for the East African Community, Khaleeji for the Gulf Cooperation Council and Caribbean guilder for Curaçao and Sint Maarten for replacing the Netherlands Antillean guilder. Iran, on the other hand, proposes a new currency, Toman in an effort to slash four zeroes from Iranian Rial.