What-Are Currencies?

We all use currencies nearly every day - either as cash or through digital transactions. But, do we really know what they are and what makes a good currency?

Currencies are money systems that are used within a particular country or region. They enable individuals, businesses, and governments to trade goods and services efficiently. They also serve as a cornerstone of financial and economic systems.

The Functions of Currencies

The three main functions of currencies are:

1. Medium of Exchange
2. Unit of Account
3. Store of Value

Medium of Exchange

Currencies eliminate the inefficiencies and uncertainties of bartering by providing a standard by which goods and services can be exchanged. Instead of trading goods directly, people use money to facilitate transactions, making trade more streamlined.

A good medium of exchange is:

• Durable
  The currency can be used without the danger of wear and damage. This has generally been solved for current currencies, but there is a slight danger of damage and wear for cash. Note that most modern transactions are digital, not ‘cash’.

• Transportable
  The currency should be easily transferred. In the last decades, there has been a shift to online transfers, but physical cash payments are still a significant proportion of transactions.

• Divisible
  The currency needs be divisible. For example, a £10 note can be sub-divided into two £5 pound notes or ten £1 coins.

• Fungible
  Each unit of currency (e.g. £1) should have the same value as any other unit.

Unit of Account

• Prices are quoted in units of currency rather than other goods.
• Prices indicate the value of goods, services, economic activities, assets and liabilities.
• In each currency zone, the main currency tends to be the unit of account.

Over the short term, major sovereign currencies are reasonably stable and certainly more stable than private cryptocurrencies. Over the long term, major sovereign currencies tend to be inflationary. This means that they lose value over time.

Store of Value

A store of value is a mechanism by which wealth can be saved and retrieved in the future with some predictability about its future value. Any asset can be a store of value, but none are perfect.

Examples of stores of value are:

• Gold/Silver/Diamonds
• Reserve currencies
• Stock/Bonds/Real Estate

All of these assets can be volatile with a risk of loss.

Types of Currencies

Fiat Currencies
Most modern currencies are fiat currencies. These have no intrinsic value but are backed by the trust and authority of the issuing government. Their value is derived from the demand for their use in the economy.

Commodity Currencies
These are backed by a physical goods, such as gold or silver. Historically, gold and silver coins were commonly used as currency.

Cryptocurrencies
Digital or virtual currencies, such as Bitcoin and Ethereum, operate on decentralised networks using blockchain technology. They are not issued by any central authority, and many aim to offer an alternative to traditional currencies.

The Evolution of Currencies

Currencies have evolved significantly over time. Early economies relied on barter systems, where goods and services were exchanged directly. This system was inefficient and impractical due to the need for a 'double coincidence of wants'.

To overcome these limitations, societies began using commodity money, such as grains, shells, or precious metals, which had inherent value. Over time, paper money and coins emerged, backed initially by commodities like gold. Eventually, fiat currencies became the norm, relying on government regulation and public trust.

In recent decades, the advent of digital technology has given rise to electronic money and cryptocurrencies. These have transformed the way transactions occur and are challenging traditional notions of currency.

Currency Markets and Exchange Rates

The value of a currency in relation to others is determined in the foreign exchange (Forex) market, which is the largest financial market in the world. Exchange rates fluctuate based on factors such as economic conditions, interest rates, political stability and market speculation.

For example, if a country's economy is strong and stable, its currency is likely to appreciate. Conversely, political instability or economic downturns can lead to depreciation.

The Future of Currencies

Currencies are continually evolving. Cryptocurrencies and central bank digital currencies (CBDCs) are reshaping financial systems and introducing new paradigms for money. As technology advances, currencies will likely adapt to meet the changing needs of global economies and societies.

Conclusion

Currencies are more than just tools for transactions; they reflect the economic health, technological advances and societal trust of a region. Whether in the form of coins, banknotes, or digital assets, currencies remain a crucial part of human civilisation, facilitating trade, fostering economic growth and shaping the world as we know it.

Acknowledgements

This article was written with the assistance of material published by the University of Nicosia.

Bibliography

Mastering Bitcoin: Programming the Open Blockchain (2023)*
Andreas M Antonopoulos  and David A Harding

* Referral link