How Currency Works

Currency is a normal part of everyday life – we withdraw cash from our banks, pay for goods with our debit or credit cards, and manage our finances through apps and online platforms.

Almost every transaction involves moving currency from one place to another, whether booking a holiday, paying for the weekly shop or ordering a cinema ticket. Still, there is a great deal of complexity and security associated with currencies, and when they shift in value, they can affect our finances.

The physical money circulating throughout the economy is only a fraction of the overall monetary supply. Most currencies primarily exist in the form of credit or as electronic data managed by a financial institution or bank.

However, coins and notes remain an essential factor of national infrastructure – so how do they denote value, and who decides what our money is worth?

Understanding Currency Basics

When talking about currency, we mean physical money used in the economy. In the past, currencies were valued according to their bullion weight or how much precious metals were held in reserve by a government.

Today, currencies are not backed by gold reserves but are valued against market confidence in the economy issuing the money.

Ancient currencies addressed problems when people bartered. If they needed to buy something, they would have to find someone with that commodity willing to accept whatever asset they had to swap.

Money is a global store of value in a universally accessible format – everyone in the UK uses the same coins and notes, regardless of what we need them for or how many we have.

The unit of a currency is called the numeraire, which is how traders and retailers price their goods. For example, in the UK, GBP – British pounds sterling – is the numeraire because this is the currency we use to pay taxes, take out credit or pay for things we buy.

Before currencies existed, gold coins or equivalent assets could be cumbersome, difficult to store and heavy, whereas today’s coins and notes are designed to be durable and lightweight.

Coatings and production techniques aim to ensure physical currency lasts for years, so once you own a material amount of money, it cannot physically deteriorate before you have a chance to use it.

How Money Worked Before Currencies

Early societies didn’t have currency notes or coins and used alternative commodities to represent standard forms of payment.

The Mayans used cocoa beans to pay for goods rather than trading one item for another, although they didn’t last indefinitely and could be challenging to transport.

Egyptian civilisations were the earliest to create the first incarnations of modern currency in the third millennium, using metal rings – coins as we know them were not invented until around 500 BC in south-eastern Europe, in what we now call Turkey.

Other examples of historic currencies include:

  • Cowrie shells in America now commonly used in jewellery making.
  • Tobacco leaves in Africa.
  • Barley and grains in ancient Sumer.

Global travel meant that some societies encountered coins from other countries. For example, the Romans used gold coins. These were similar enough to those used in India and China that traders would accept the alternative currency – but not necessarily at like-for-like swaps.

For example, if one country used thinner coins or silver instead of gold, a coin might be considered worth half a local coin, and thus the origins of exchange rates and forex were born.

Paper money was first used in the Chinese Tang Dynasty around 806 AD, whereas other cultures used metal coins made from copper, silver or gold.

Electronic currencies are far more recent and were introduced by Western Union in 1871 when it transmitted the first-ever money transfer.

As computers became more accessible and advanced, banks looked to use electronic transfers to expedite transactions and develop international banking systems, allowing account holders to credit or debit another account without physical cash changing hands.

Establishing Trust In Currencies

Before currencies were widely available, a tangible commodity such as rice was a far better trading opportunity because it held an inherent value. It was something you could cook or swap for another item if you already had enough food.

The key to a functional currency is that we trust it, and so does everyone else; this is the underpinning factor that makes an economic system work.

If we all accept that a printed piece of paper is worth one dollar or ten pounds, it becomes valuable, provided everyone buys into the concept.

Part of this concept relies on the issuing government to be reputable and perceived as an authority, so the money it prints is accepted as holding the face value printed on the coin or note.

Coins and notes are today printed with identification codes and coats of arms, flags or text that marks which government or kingdom has issued them, modelled on the first coins that the king guaranteed, and bore his stamp as proof of value.

Representative money

The gold standard was a system whereby currencies were valued because owners could exchange them for a stated amount of a commodity, usually gold.

Central banks, including those in the UK and US, held a proportion of gold in their reserves and would pay a static value in gold ounces for each currency unit. Therefore, a banknote or coin was worth the weight of the metal a bank would give in exchange.

Much of this changed after World War I, when runs on gold supplies, scarcity in mining and the need for central banks to control economies meant that representative currency models had stopped being viable.

Countries began leaving the gold standard and changed from representative to fiat money, which holds value because users have faith that vendors or traders will accept it.

Every major currency is now a fiat denomination, including US dollars, British pounds, Japanese yen, and euros.

Currencies And Exchange Rates

Financial markets trade currencies based on exchange rates determining how much one currency will buy of another.

Governments can manage exchange rates in different ways.

Fixed exchange rates mean the government pegs the national currency against another, usually a large currency such as euros or US dollars. There is a confirmed exchange rate, and the central bank can buy or sell the pegged currency to influence the local exchange rate.

Pegged exchange rates are used where the government needs to create a stable economy and are more common where the local financial markets are less advanced. For example:

  • Bermudian dollars are pegged to US dollars at a rate of 1.0.
  • The Danish krone is pegged to euros at 7.46038.
  • The Jersey pound is pegged to pound sterling at 1.0

There are potential downsides to pegged exchange rates, where the central bank buys too much local currency and creates an overvaluation.

The alternative approach is a floating currency, where forex market demand and speculation influence the value. Most major economies have floating currencies.

Traders monitor political, economic, and global indicators to try and forecast when a currency will become stronger or weaker and, therefore, worth more or less in exchange with another base currency.

Because of the nature of fiat currencies, which derive value from trust and confidence in the issuing government, any disruption, political uncertainty, or underlying economic performance factors can directly impact the floating exchange rate.

How Currency Works FAQ

How are currency values determined?

Most currencies have a floating rate, which means the value can go up or down depending on demand through the currency markets. Fixed rates apply when a currency is pegged to another and remains at that static value – although the exchange rate will differ if the parent currency fluctuates.

Which currencies are considered the safest?

The strongest currencies are often considered to be the Swiss Franc, CHF, or the Kuwaiti Dinar, KWD.

When were currencies first created?

Currencies have existed for hundreds of years in different forms but were first used around 5,000 years ago when Mesopotamians started exchanging shekels.

Gold and silver coins are still around today, which were first issued in 650-600 BC and used to pay soldiers.

How much money is in circulation in the UK?

The Bank of England produces new banknotes through an Essex currency printing facility and adjusts printing rates depending on when new notes are issued, how many notes are in circulation, and the proportion that is returned, damaged or no longer in good enough condition to use.

Around 4.7 billion British bank notes are in circulation, worth around £82 billion.

What is the difference between money and currency?

Both terms mean the same thing. So, for example, although currency is physical cash, money might refer to credit accounts or electronically stored value.

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