Money vs. currency

Is there really a difference between money and currency? Well yes – a significant difference. Money is the general term used for any commonly accepted “medium of exchange”. Money can exist in any form – most com- monly an object or maintained record of transaction which is acceptable by the significant majority of people as payment for goods and services. Currency on the other hand is the name for the commonly accepted form of money that is in circulation. In most cases currency is represented as banknotes and coins but its definition can also encompass anything that is commonly held to represent value and is accepted on those terms.

In everyday speak money and currency are interchangeable terms however in precise usage it’s important to note the difference, e.g. Barney Stinson has a lot of money but if he buys a suit in Italy he better make sure he has the right currency (Euro).

Money is therefore the broader term used to talk about wealth, value and the ability to acquire goods and services. Having a lot of money is good, but having a lot of any currency depends on what the currency is – for instance its better to have one United States dollar as currency than ten thousand Indonesian Rupiah as currency.

Historically, money has found many forms in societies and economies, from a simple honour bound promise between ancient farmers (“I owe you”) to the hard cold cash of today. Interestingly, the evolution of the “I owe you” essentially gave birth to “I owe you one unit of…” – that blank space was filled with many different things over time including – grains, cattle and shells – all of which were valid money currencies of their time. However as societies grew and began trading with other societies the need for a universal “store of value” gave birth to minted money that was based on precious metals i.e. gold and silver.

Within the modern context currencies have continued to evolve (as with the creation of the Euro) but money has, for the longest time, held certain fixed features; to be a medium of exchange, a unit of account and a store of value. However, in the post-modern digital age, currencies such as Bitcoin are even testing these features.

What is currency?

Currencies are rigidly defined by the systems or economies they are com- monly used in society. In the modern economic usage, they are primarily “stores of value” – which means that they assure all users that they are worth having due to their assured value. Although the degree and relative nature of that value may differ, it is stable and generally known. E.g. the Indian rupee is an assurance of value in the Indian system but it may not be easily used in China, but it can be traded for Chinese currency of equal value through established systems.

All across the world the different currencies are traded on foreign exchange markets under the careful watch of government regulations. Since each currency is established and regulated by national governments, they represent the economic power and stability of the nation’s economy and require monitoring. As recent international economic developments have shown, the economic strength of any nation is first felt in the strength of its currency.

Some currencies, such as the United States dollar, are near-universally accepted across the world due to the relative strength of its national economy, whereas the former (2009) currency of Zimbabwe ran out of steam with a 100 trillion dollar note that was even then less valuable than one US dollar. Currencies are constantly changing in value across markets as countries continue to trade with each other but there are a handful of currencies that are broadly accepted – the Euro and US dollar – being the preferred ones.

Due to the nationally critical nature of this form of money, currencies are produced under extremely controlled setups by governments. Often times these currencies, usually in the form of banknotes, function as a written statement of promise or contract between governments and those who possess the notes. This can be seen on the Indian currency with the words – “I promise to pay the bearer the sum of X rupees” – which is signed by the Governor of the Reserve Bank of India. The currency in this sense functions as a bond of trust, which is key assurance of value that national currencies enjoy.

History of Value in currency

Currencies as stores of values are critical for national and international economies. But the question of their value is constantly under debate. What makes the US dollar so much more valuable when compared to the Somali shilling (15,000 Somali shillings for 1 USD in May 2013)? Where do currencies get their value from? To first understand the notion of value it is important to note the history of money and nations.

The early form of money that found widespread acceptance was in the form of precious metals – gold and silver. The desirability of these metals across diverse cultures made them the ideal medium of stored value. Traders from different parts of the world could securely trade goods and services for pieces of gold and silver. But as the scale of trade increased across distances and quantity it wasn’t practical or safe for traders to carry around hundreds or thousands of valuable metal pieces with them. They were just too heavy.

In order to simplify this problem without disrupting trade the concept of “notes” was created. First used in 8th century China, a piece of paper was created to represent the value of the metal coins that were to be traded. However these “notes” needed to be guaranteed by a trustworthy party, which is where banks came into existence. Traders usually traveled back and forth between fixed locations and made diverse trades with many people. So banks would hold the coins for traders and issue them “notes” that were accepted by other parties who trusted the banks. The building of trust was therefore the banks job and this led to banks having branches in various cities so they could process trade.

Trader A would typically deposit X number of coins in a bank and receive a “notes” of that value. When making a trade, A would pay Trader B using the “notes” issued to him by the bank in his city. When trader B went to trader A’s city the same note could be used to pay. As long as all parties involved trusted the bank trade could carry on. Over time this system became more efficient to account for various possibilities such as “what if trader B didn’t go to trader A’s city” and so forth. The solutions of these types of issues led to the modern economy where nations and banks were entrusted with guaranteeing the value of “notes” or currency as they became over time.

For the longest time all currency issued by nations was guaranteed by deposits of gold in their reserves. The assurances printed on currency notes such as “I promise to pay the bearer a sum of X…” meant that an individual could theoretically go to the national reserve and exchange the “note” currency with X value of gold. However, this was rarely ever done or necessary and the international economies continued to move on trust – of the fact that there actually was gold of equal value in the reserves. This was known as the “Gold Standard” and was formally entered in to by 44 nations in 1944 as a part of a new international economic system that would allow global trade. This decision was taken at the United Nations Monetary and Financial Conference or the Bretton Woods Conference. The agreement also gave birth to the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). Currencies were tied to the U.S. dollar and the IMF managed any intermittent imbalances of payment between nations. This form of currency system in domestic and international economies found value from its gold reserves. As long as gold remained a valued com- modity, the currency representing it was considered valuable. Clearly this proved harder to apply in the long run than it was initially thought. The necessity of having an equal amount of gold in reserves forced banks and nations to keep accumulating the metals as currency demand increased. And the use of gold and silver in industrial processes’ became a far more pressing concern since you could either store the metal as reserve for cur- rency or lose it in an industrial process. The pressure on maintaining enough reserves as populations and currency demand increased became a problem.

 

At first the solution to the problem was simple – to break its own rules. Instead of maintaining a 1:1 ratio In order to replace the hard to manage metal, the value of trust became more important. It no longer mattered if there was enough gold or silver to represent the currency value, what mattered was if everybody was still willing to accept the currency itself. And     as long as the currency was backed by a sovereign nation and government that was trustworthy  trade  could  continue.  This  realisation  eventually  led to the abolishing of the gold standard by US President Richard Nixon      at the 1971 meeting of the Bretton Woods Conference. The United States ended its USD to gold convertibility and declared the dollar to be a fiat currency which essentially led the US dollar to replace gold in the reserves of most countries. So to the question of what gives currency its value – the trust of its users and its continued demand. Trust and demand-As long as something, anything – oil, gold, pieces of specially stamped paper, digital currency – is in demand it will have value. In the modern economy the one object that was the widest possible demand is currency – some more than others. And the reason behind that demand is the inherent trust of the users that everyone else also wants it. Any currency would be useless if nobody wanted it. It seems like a strange trick but it’s the foundation of modern economics.

As long as enough people believe in the value of money the global engine of trade keeps on running. If suddenly people lost faith in the value of currency it would be nothing more than bits of paper and metal. As long as this dual coincidence of wants remains in an economy currencies will always have value. Of course, the relative value of currencies differs – since that is based on a multitude of factors – the biggest one being the demand of the currency itself. The reason the US dollar is considered most valuable is because it is the one currency that is globally in demand. This strange circular logic of coincidental wants grew from a more rational foundation – that after the Second World War the only country that was prosperous in the world was the United States. Most nations were indebted to it in huge amounts or had been devastated by the war. This tangible advantage allowed the US currency to reflect the strength of its nation and since then has continued to (through controversial means) remain the most powerful currency in the world as well as the most valuable.

 

Who controls currency?

As we’ve discussed, currency is a representation of national wealth, power and value. It derives its value from trust and trade utility. But in order to administer its flow across borders and within nations a system is necessary. This system is part of every country’s setup and is known as the central bank. And the institution that coordinates and administers the planning of these many central banks is the Bank for Inter- national Settle- ments (BIS) in Basel, Switzer- land. However, the BIS has no direct control over the currencies of various nations and is involved only in monetary policy guidelines that its 58 member nations have to adhere.

Although the BIS is an important part of the international network of trading economies the actual control over currency comes from the specific central banks and national monetary policies of economies. Currency or “minted” money i.e. notes and coins, is manufactured by governments of nations through monetary policy enforcement that allows them to introduce increase the “money supply” in their economies. This process is highly sensitive as the rampant creation of currency can destabilize economies and is done with great care and timing. It is a necessary part of managing a nation’s monetary policy and is therefore very carefully administered.

Changes of lower impact such as the introduction of new coins or notes and the erasure of older denominations of currency are occasionally necessary to keep up with market forces such as inflation. Other ways of control- ling currency in a national economy such as devaluation and redenomination are also strictly in the realm of governmental economic policy. Any changes to a national currency are a complex and fairly transparent process in most countries. This exposure limits the volatility with which changes can be made to manipulate the appearance of an economy. The control over currency isn’t as direct as some people might fear.

How does a currency’s value change?

The value of all currencies is in constant fluctuation but usually within    a very finite range. In the course of a day the value of the Indian rupee rarely fluctuates beyond tens of paises and is the general reflection of the impact of demand and supply on the currency due to ongoing trade. The changes in value of a currency brought on by these trade or market forces is considered completely natural and fair. The best means for a currency to remain valuable is to ensure that other nations require the domestic currency to make trade.

A simple example is as fol- lows – an Indian wants to buy a car from America. To do so she will have to make the payment in US dollars since no American car company will accept Indian rupees (since no one sells anything in America in exchange for Indian rupees). In order to obtain the dollar the Indian will trade her rupees for dollars from a currency exchange and make the payment. This increase in the demand for the dollar will make it stronger and increase its value. However, if an American wants to procure the services of Shah Rukh Khan, she will similarly have to trade her dollars for rupees, which in turn would increase the value of the rupee. As long as the demand for American goods outweighs Indian goods between the two countries, the rupee will never be as strong as the dollar. But if suddenly India is selling more goods to America than buying from America, the Indian rupee will get stronger and more valuable. This fluctuation in the trade between not just two nations, but many nations in various permutations and combinations in an ongoing non-stop flow causes the currency’s value to change. The simplest way for a nation to positively affect the value of its currency is to increase its demand by exporting more goods and services to other nations.

 

Conversely, when any nations productively is hampered and it ends up importing more than exporting, the value of its currency is weakened. Its interesting to note that in 1966 the value of a US dollar in Indian rupees was 7.5:1 and is currently (January 2014) around 61:1. This reflects how the balance of trade between the two nations can broadly be considered.

Other ways of changing the value of a currency lie in the hands of the government and the central banks of nations. As mentioned earlier, changing monetary policy to increase or reduce currency supply can also have an effect on the value. In addition to which practices of devaluation can also cause changes in value. Devaluation is the monetary policy whereby the government or the central bank intentionally decreases the exchange rate of its currency with another currency. The reasons behind why this is done are mostly to do with the management of lagging trade and struggling economic development, and the currency devaluation is a tool used to manage the problem. However any move to do so is usually seen as a panic indicator and causes more problems than its fixes.

The balance between import and exports greatly influences the value of any fiat currency.

How is currency power?

The world is a much smaller place than it was a hundred years ago, especially in economic terms. Never before was it possible for an Indian tea farmer in West Bengal to purchase a cell phone designed by engineers in America and assembled by workers in China, that was marketed to him via professionals in India based on an international advertising campaign created in London. And customer service in his own district of Jalpaiguri.

The reason the international system of trade is able to sustain itself   is due to the commonly held belief that all currency has value – some more than others but value nonetheless. And by trading currency for goods and services in multilateral ways across various nations can an efficient system of resource management be created which results in better products and services at the most competitive prices. However, all this is easier said than done.

The real world behaviour of people in this system is oriented towards winning, not towards fairness or efficiency. A major example being the spending of hundred of millions of US dollars annually by competitors like Pepsi and Coke to promote their product over the other when essentially they are both carbonated sugar water – not very efficient and yet very necessary if they wish to remain profitable. This conflict between the design of international economies and the private players who operate within them makes currency the source of all power.

A nation may choose to orient its power in different ways but the end goal is the same – to retain an advantage over other nations in the eco- nomic exchange. The work towards this advantage nations need to make products and services flow out of there country in a higher ratio than they flow into the country. By maintaining this balance of exchange they can increase the demand of their currency and directly have more power. Since the end of the last world war, most of the world has imported from countries such as America and Middle-Eastern oil nations. Only since the ‘90s has widespread globalisation allowed a wider exchange between countries but the advantage is already in the favor of select nations.

From making purchases of everyday items to starting a new business, the reality is this – currency is power because it allows you greater freedom and liberty in fulfilling your desires.

Glossary of Money – We’ll briefly explain the meaning of certain terms that will assist in understanding the concepts around money and currency more clearly.

Fiat currency or fiat money

The word “fiat” is latin and means “it shall be”. In connection with currency it is the term used to describe any form of money that is under the control of a government and is considered a legal tender. Fiat currency or fiat money is produced, controlled and managed by national governments and unlike gold or silver currency has no intrinsic value. For example, a 100 rupee note is not produced from materials that are valued the same as its face value but is valued because it is a fiat currency supported by the government.

 

Veil of money

Almost all forms of modern currency are fiat currencies or currencies dependent on fiat currencies. The veil of money relates to the question of whether money itself is like other commodities (like gold) or does it have any intrinsic quality of its own. Over time this theory has gone from saying that money by itself is useless and is only of value in exchange of actual goods or services to the current belief that it is simply a store of credit and holds value when it is treated as valuable. In economic studies it takes on a more technical meaning related to interest rates and monetary policy by the government.

 

Central banks

A central bank or reserve bank is the main authority within a nation that manages a country’s money supply as well as its production and manipulation through interest rates and other enforcements of mone- tary policy. It is created to administer and guide the commercial banking activities in a country along with the power to penalise and punish fraudulent acts. They are not directly controlled by government agents and function with a mixed authority from the executive and legislative branches of government. In India, the Reserve Bank of India has this duty.

 

Tinkerbell effect

The Tinkerbell effect gains its moniker from a character in the play Peter Pan, where a fairy – Tinkerbell – exists only as long as people believe in the existence of fairies. The similar association is made in economics between money and its value. Money is valuable as long as people continue to believe that it has value.

 

Friedman rule

The Friedman rule is a technical concept in monetary policy, named after economist Milton Friedman. The rule is meant to define an association between interest rates set by central banks and the money supply in the market. The rule says that the interest rate should be such that the money held by persons would retain its long term value and not depreciate. By balancing the central bank interest rate with the rate of currency deflation, a nominal interest rate of zero could be achieved. This is an ongoing debate depending on various factors of an economy intended to outline the ideally preferred scenario.

 

Money illusion

This term defines the conceptual flaw in thinking when referring to the value of money over time. A simple example is that in the if the price of an ice cream in year 2000 was 10 rupees, the expectation in the minds of people is that it will continue to be 10 rupees in 2014 even though the value of the 10 rupees has reduced since 2000. That is, the face value of money is mistaken as its real value or purchasing power. However, as we know since fiat currencies have no intrinsic value, the face value of currency can remain the same while it real value continuously fluctuates. People continue to not recognise this in certain situations – a common example being when in experiments they consider a 2 percent reduction in income with steady prices as unfair but consider a 2 percent increase in income with 4 percent inflation as being fair, even though both scenarios are mathematically identical.