What’s it: Currency refers to the money accepted and used as legal tender in a country. It includes banknotes and coins you use daily. The central bank or authority acts as the sole supplier and monitors its circulation in the economy.
Currencies have been used in modern economies and around the world to facilitate transactions between countries. A currency’s purchasing power against another is called the exchange rate.
A brief history of currency
Before currency was introduced, we used a barter system to exchange goods and services for other goods and services. Barter transactions have several disadvantages, including the difficulty of accurately determining the value of goods or services. Eventually, it started to disappear, and then the modern economy used the money to facilitate exchange.
The first use of currency comes from ancient Egypt. During that time, the currency was a form of receipt representing an individual’s right to claim grain stored in temple barns in Ancient Egypt.
Then, coins such as gold and silver became the new intermediaries in trade transactions. Entering the era of the gold standard, banknotes came into effect in several major countries. In fact, it had appeared in China in the years 618–907, but its use was relatively limited.
Under the gold standard, the value of banknotes was based on a fixed amount of gold. I mean, when we hold it, we can exchange it for some gold bills.
Furthermore, in the modern monetary system, paper money is no longer backed by gold. We value it and use it in transactions because the government guarantees and recognizes it as legal tender.
Examples of currencies are the rupiah in Indonesia (IDR), the US dollar in the United States (USD), the Euro in the Eurozone (EUR), and the yen in Japan (JPY). In total, there are 180 currencies currently around the world. They are recognized as legal tender by the United Nations.
There are several currency terms and classifications; the following are among them.
- Reserve currency. The central bank holds it as a foreign exchange reserve because of its relatively stable value and is widely used in international trade. The US dollar and the Euro dominate about 60% and 20% of global foreign exchange reserves, respectively. Next, there are the Japanese Yen, Pound sterling, French franc, Chinese renminbi, Canadian dollar, Australian dollar, and Swiss franc.
- Hard currency. Hard currencies have a relatively stable purchasing power against other currencies over time. They come from countries with strong and stable economies and politics, including economic growth and inflation rates. They serve as a medium of exchange and are widely used in international transactions, and serve as a reliable store of value (thus used as foreign exchange reserves). Another term for hard currency is a strong currency or safe-haven currency. Examples of hard currencies are the United States dollar, Euro, Swiss franc, British pound, Japanese yen.
- Soft currency. We also often refer to this term as a weak currency. It usually comes from countries with an unstable economy and politics, resulting in its value fluctuating and depreciating significantly. Forex market participants tend to avoid it.
Purchasing power of currency
Currency purchasing power refers to the number of goods and services you can buy with the currency you have. We also often refer to it as the real value of money. If you get more goods than before for the same amount of money, it means your money’s purchasing power increases. Conversely, purchasing power decreases when you get fewer items.
Purchasing power concept also applies to currency trading. We specifically call this the foreign exchange rate. Say you convert domestic currency into foreign currency. In that case, the domestic currency’s purchasing power is stronger when you get more foreign currency. For example, if you exchange 1 US dollar, you get IDR14,000. It means that the purchasing power of the dollar against the rupiah is higher.
Impact of inflation
The main factor affecting the real value of money is inflation, both of which have an inverse relationship. When inflation is high, the real value of money falls. The prices of goods, in general, go up significantly, so you get fewer goods with the same amount of money.
For example, you buy a product for IDR100. If the price goes up to IDR200, you can only buy half of it. We call the condition when inflation increases significantly hyperinflation, which creates instability in the economy.
Likewise, deflation (negative inflation) also harms the economy. Indeed, the real value of money increases, and you get more goods for the same nominal value. But, it hurts businesses because they earn lower revenue and profits, assuming unchanged sales volume. Deflation also increases the debt’s real value (debt deflation).
Currency exchange rates
Exchange rates refer to the purchasing power of one currency against another. Assume you are Indonesian. The rupiah exchange rate against the US dollar means how many US dollars you get when you exchange your rupiah.
For example, the rupiah exchange rate is IDR14,000/USD. That means, to get 1 US dollar, you have to exchange IDR14,000. When the rupiah’s purchasing power against the US dollar strengthens (appreciation), you have to exchange less rupiah for getting 1 US dollar, for example, from IDR14,000/USD to IDR13,000/USD. Conversely, when the rupiah’s purchasing power weakens (depreciates), you have to exchange more rupiah for getting 1 US dollar, for example, from IDR14,000/USD to IDR14,000/USD.
Foreign exchange market
Currency trading has become popular in the modern economy. It began to develop in the 17th and 18th centuries, with Amsterdam being home to its first currency exchange market. This market allows buyers and sellers of foreign currencies to transact legally.
Now, the foreign exchange rate market (forex market) has expanded widely, involving not only a few countries but all countries in the world. It facilitates capital flows and international trade, enabling individuals and companies to invest and buy goods abroad.
Market participants use the forex market to hedge their risks, using a combination of spot, forward, swap, and option contract. Others use it to speculate and gain short-term profits through triangular arbitrage.
Transactions on the foreign exchange market are highly liquid, although they are also more volatile than the capital market. Market participants come from various parties worldwide, including banks, companies, individuals, governments, central banks, mutual funds, and pension funds. The Bank for International Settlements reported that transactions on the foreign exchange market reached an average of USD6.6 trillion per day in April 2019.
Factors affecting currency exchange rates
Exchange rate system. Suppose the government adopts a fixed exchange rate system. In that case, the exchange rate does not move to adjust the supply and demand on the foreign exchange market. Conversely, under a free-floating system, exchange rates fluctuate according to supply and demand conditions.
Balance of trade. Exports encourage the appreciation of the domestic currency as it increases demand. Thus, its purchasing power is strengthened relative to the partner country’s currency.
Conversely, imports result in depreciation of the domestic currency because it increases the partner country’s currency’s demand and purchasing power.
Overall, the trade surplus leads to an appreciation of the domestic currency as exports outnumber imports. Meanwhile, the trade deficit results in depreciation because imports are higher than exports, ceteris paribus.
Interest rate spread. Suppose the domestic interest rate is higher than the international interest rate. In that case, it attracts an inflow of foreign capital. It increases the demand for domestic currency, leading to appreciation.
Likewise, the narrower interest rate spreads due to rising domestic interest rates (while international interest rates are constant) also has the same effect. It makes returns on the domestic market more attractive, encouraging inflows.
Inflation rate. Inflation represents an increase in the prices of goods and services in general, including export products. High inflation makes domestic products more expensive and less competitive in international markets, reducing demand by overseas buyers. As a result, exports decline. It leads to domestic currency depreciation against partner countries’ currencies, ceteris paribus.
Economic policy. For example, the expansionary monetary policy increases the currency supply in the domestic economy. That leads to inflation and a decrease in the purchasing power of the domestic currency.
Speculative activity. Speculators can influence exchange rates by buying or selling certain currencies, causing changes in supply and demand in the market. They usually take short-term profits by trading several undervalued or overvalued currencies.