Evolution of currency can be linked with the evolution of trade. During early days people used barter system for trading. As part of barter system goods were exchanged with one another. For example a farmer would exchange wheat grown on his farmland with rice from another farmer. However barter system had issues with respect to – 1) desire to trade by various parties involved, 2) pricing, 3) sub-division into smaller quantities and 4) cost of transportation. Therefore in order to make trading easy a need for a common medium of exchange was felt. This lead to creation of money. During initial stages, people tried various items ranging from food to metals as a common medium of exchange. Gradually gold and silver metal coins became most prominent mediums of exchange because of ease of transport, divisibility, certainty in quantity and universal acceptance. Further evolution in trade lead to development of paper money. Each country has its own money, which is accepted within the boundaries of the nation. When money is branded then it is called Currency. Some common currencies across the world are Indian Rupees (₹), US dollars (US$) and European euros (€).
In the modern world, most of the money is created by banks by undertaking different financial transactions like accepting deposits and by giving loans. Whenever a bank gives money as loan new money is created. Today, a bank does not give out currency notes worth thousands to create new money rather they just make credit entry into your bank account equal to the loan amount. At this point, new money is created out of nothing in form of bank deposit into your account. The dark side to this practice is that it creates very large loan books out of nothing rather than from borrowing someone else’s life savings. And over a period of time this can lead to waves of defaults and financial crisis when loans becomes too large.
Currency has three major functions –
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- Serves as medium of exchange – Currency acts as a medium of exchange to facilitate trade transactions by having universal acceptance of all parties involved, regardless of their desire to trade each other’s goods and services. Thus to serve as medium of exchange is the most important function of currency.
- Store of value – In order to serve as medium of exchange, currency must hold its value over time. That means, it should store value otherwise it will not be accepted as a medium of exchange. As a store of value, currency is not unique; many others exist, such as land, gold, and collectibles. Further, Currency is not the best store of value because it depreciates with inflation. However, Currency is more liquid than most others because as a medium of exchange, it is readily accepted everywhere and can easily be transported in a convenient manner.
- Unit of account – Currency also serves as a unit of account, by providing a common measure of the value of goods and services being exchanged. By knowing the value of a good, in terms of currency, both buyer and supplier can make decisions about how much quantity to buy and sell respectively.
Over period of time with improvements in communication and transportation systems, people started traveling to different countries. This lead to further expansion of trade as people of different countries started trading with one another leading to evolution of foreign exchange (FX) i.e., value of one currency versus value of another currency. Whenever there is cross-border travel and/or trade there is need to exchange one currency for another, and this is called “foreign exchange” or simply “forex” (FX).
Foreign exchange transactions are central to global trade. The foreign exchange market consists of various investors, banks, businesses and governments who trade in overseas currencies. These markets function 24/7*365 days and are the largest in the world. According to bank of international settlements triennial report of 2016, average daily market capitalization of FX markets is about 5.1 Trillion US Dollars.
People acquire foreign exchange so they can purchase goods and services overseas. Alternatively, businesses might receive payments in foreign currency and require to convert that money back into domestic currency via foreign exchange. The foreign exchange market also serves the purpose of attracting investors. Investors diversify and increase their asset holdings with different currency reserves.
Foreign exchange rates also function as leading economic indicators. Investors and institutions analyze these foreign exchange market trends to create wealth and manage risks. Some of the most traded currencies in the world are – US dollars (US$), pounds sterling (£), Canadian dollars (CAD$), Japanese Yen (JP¥), Australian dollars (A$), European euros (€) and Swizz franc (CHF). And the most traded currency pairs are EUROUSD, USDJPY, GBPUSD, AUDUSD, CADUSD and USDCHF.
Conclusion
In this article, we have provided you information about evolution of money, its use, and how it is created. Further we have introduced you the concept of global trade and foreign exchange. For more information please feel free to reach out to us via email at – enquiry@taptoprosperity.com or by phone – 91-9515475381.
Next Article – Asset Allocation Part – III : Introduction to fixed income securities.
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