Basics of Currency

So far in financial literacy month, we’ve talked about banking, saving, and investing, but today we’re going to focus in on money itself.

Currency is any money that is acceptable as a medium of exchange. Typically, that means a government-backed money, issued either in paper or metal coins.

National Currencies

Each country typically has a unique currency. The US has the dollar ($), Korea has the won(₩), Japan has the yen (¥). Some countries will use national currency from another country. Ecuador, El Salvador, Micronesia, and a few other countries use US dollars instead of their own national currency. When countries do this, it is called dollarization. This can help stabilize a country’s economy, but gives control over interest rates and monetary policy to the US Federal Reserve.

Some countries accept multiple currencies. The official currency of Zimbabwe can currently be US or Australian dollars, Chinese yuan, Indian Rupees, Japanese yen, South African rands, British pounds sterling, Botswana pulas, or Euros. They switched to this multi-currency system in 2009 after hyperinflation led them to issue 100 trillion dollar bills of their own currency. (See more about hyperinflation in our post on the Basics of Inflation.)

The Euro is a special currency for the combined countries of the European Union. Where France used to have francs as its unit of currency, and Germany had Deutsche marks, now they use the Euro. Some smaller neighbors to the EU like Kosovo, the Vatican, and Monaco also use the Euro.

Britain may have voted to leave the EU in 2016, but they always had one foot out the door; they continued to use the pound Sterling rather than switching to the Euro like other countries in the EU.

Many African countries also share a currency; the West African franc is used in 8 countries and 6 countries use the Central African franc.

Currency Exchanges

Currency exchanges, or foreign exchange markets, allow people to trade one country’s currency for another. There is an official “exchange rate” that sets the value of one currency relative to another. (You might see this called the forex rate, for “foreign exchange”.) As this post is being written, the US dollar is worth .78 British Pounds Sterling.

Investors who trade in international markets need to keep track of exchange rates. If the dollar starts declining in value compared to foreign currencies, international holdings become more valuable, and if the dollar gains strength, international investments become less valuable.

Some investors make money simply on trading currency. If one thinks a particular currency is over-valued on a currency exchange, one could short-sell that currency and make money when its value goes down. (Learn more about Short-Selling in our post on the Basics of Investing.)

Cryptocurrency

The rise of bitcoin has made non-governmental currencies a realistic option. Previously, privately issued currency was risky, because if the private issuer of a monetary note disappeared, the money was left worthless. Bitcoin and other digital currencies rely on modern technology to add safety and stability to private currency.

This works through the use of a “blockchain”. This is a database that is shared publicly. Everyone can be connected to it and see it update and change. This database is a kind of financial ledger that tracks all of the bitcoins in circulation. If you transfer a bitcoin, the ledger that everyone sees is updated. If you tried to spend that same bitcoin again, you would be denied because the blockchain already records the previous transaction. This prevents fraud. The blockchain isn’t controlled by anyone, either, so there is no way for it to be manipulated, and since it is stored everywhere, there is no central location to be attacked or hacked to disrupt the blockchain.

Advantages of Money

All of this currency, whatever kind you use, serves an important function in any economy. Money creates a common unit of value for trading that makes it possible to store value. In prehistoric times, I might trade you a fish for an apple, but what if apples aren’t in season yet? With money, I can sell you that fish for a dollar, then when the apples are harvested, I can give you a dollar for an apple.

Economist Walter Williams calls money a “certificate of performance.” You get a dollar for doing something that benefits someone else-some amount of work, or selling something of value. That dollar represents some service to others that can be redeemed for other things of value.

Disadvantages of Money

Money doesn’t necessarily hold its value very well. There are international exchanges, like we mentioned above, that can mean your dollars’ value disappears when you cross an international border. Inflation, too can reduce the value of your dollars relative to goods and services.

Here’s an example. 100 years ago, in 1917, say you had $18.99. Looking through old catalogues, we see you could buy a man’s suit for $15.00, a silk shirt for $1.98, a necktie for ¢.35, and a pair of leather men’s shoes for $1.55. You’ve spent $18.88 cents to fully clothe a man with your money. What could you buy for $18.99 today? The cheapest pair of men’s leather dress shoes at Sears (a retailer that was around in 1917) today costs $16. That leaves 2.99 for the suit, shirt, and tie. You see where we’re going. Inflation has made your 18.99 worth far less today than 100 years ago, when it would have gotten a man ready for work in a nice suit, silk shirt, and leather shoes.

Why did we choose $18.99? Because that’s the value of one ounce of gold in 1917. That same ounce of gold today is worth $1,237.90. That would buy you a pretty nice suit! You can see gold holds its value better than money does.

The important thing to know is that storing money under the mattress means it loses value. You must save in a way that earns interest and beats the inflation rate so your savings don’t dwindle over time.

The end of Financial Literacy Month is drawing near. We hope you’ve learned a little bit so far—any amount of financial literacy gained is a win! Remember, you can call us any time for personal, confidential debt counseling.

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