Currency

The term currency generally refers to the official means and regulations of payment of a country or region, which have been legally introduced and which are accepted (by law) as a compensation for goods and services. Currency includes banknotes and coins and represents a subcategory of money. Money refers to all means of exchange, also gold, whiskey, tobacco, and other commodities. Currencies, however, are means of payment that are produced and regulated by the government and do not represent goods on their [Page 453]own. Their intrinsic value (i.e., the physical value of a currency) does not coincide with its traded value.

The production and issuance of currencies is, in most cases, incumbent on national central banks or a single central bank for a certain currency zone, such as the European Central Bank, which is responsible for the European Monetary Union. Such institutions regulate the money supply in order to guarantee price stability and, thus, avoid inflation.

Today, about 160 different currencies exist which have, according to their name, an ISO 4217 currency code consisting of three alphabetical letters. They are used in international trade, e.g., EUR for the euro or USD for U.S. dollar. In order to buy goods from any other society it may be necessary to have foreign currency. Therefore, currencies can also be subject to trade and the value of one currency in terms of another currency is expressed by the exchange rate. For international trade, very often leading currencies (i.e., currencies that are preferably used in cross-border transactions) are chosen. They can be easily traded internationally and are often chosen to lock out the exchange rate risk, because they are considered more stable than other currencies. Such leading currencies include, among others, the U.S. dollar, the euro, the yen, the pound sterling and the Swiss franc.

Functions and Characteristics

A currency fulfills three main functions: medium of exchange, unit of account, and store of value. As a medium of exchange, a currency allows its holder to exchange it for any good or service that he or she requires. That is, the seller of a product is not confined by the products of his clients, as would be the case in barter transactions, where goods and services are exchanged without money. Therefore, currencies give their owners more flexibility. It is necessary that people trust in a currency as a medium of exchange, i.e., that they can reliably exchange it for other goods or services. This is of special importance if the traded value of the currency does not reflect the real value of the material that the currency is made of; for example, banknotes may indicate a higher value (printed on the surface) than their real, physical value (i.e., the value of the paper) represents. In order to guarantee that the nominal value of a banknote equals the real value of goods and services, its issuer has to hold reserves of commodities (such as gold) that guarantee the nominal value. In case of inflation (i.e., a decrease in the value of a currency), market agents may lose their trust in a certain currency and shift to barter transactions to exclude the risk of a devaluing currency.

...