How Currency Works

Money alleviates this problem. It provides a universal store of value that can be readily used by other members of society. That same baker might need a table instead of shoes. By accepting currency, he can sell his goods and have a convenient way to pay the furniture maker. In general, transactions can happen at a much quicker pace because sellers have an easier time finding a buyer with whom they want to do business.

Because of the global nature of trade, parties often need to acquire foreign currencies as well. Governments have two basic policy choices when it comes to managing this process. The first is to offer a fixed exchange rate.

Here, the government pegs its own currency to one of the major world currencies, such as the American dollar or the euro, and sets a firm exchange rate between the two denominations. To preserve the local exchange rate, the nation’s central bankeither buys or sells the currency to which it is pegged.

The main goal of a fixed exchange rate is to create a sense of stability, especially when a nation’s financial markets are less sophisticated than those in other parts of the world. Investors gain confidence by knowing the exact amount of the pegged currency they can acquire if they so desire.

However, fixed exchange rates have also played a part in numerous currency crisesin recent history. This can happen, for instance, when the purchase of local currency by the central bank leads to its overvaluation.

The alternative to this system is letting the currency float. Instead of pre-determining the price of a foreign currency, the market dictates what the cost will be. The United States is just one of the major economies that uses a floating exchange rate. In a floating system, the rules of supply and demand govern a foreign currency’s price. Therefore, an increase in the amount of money will make the denomination cheaper for foreign investors. And an increase in demand will strengthen the currency (make it more expensive).

Most of the major economies around the world now use fiat currencies. Since they’re not linked to a physical asset, governments have the freedom to print additional money in times of financial trouble. While this provides greater flexibility to address challenges, it also creates the opportunity to overspend.

The biggest hazard of printing too much money is hyperinflation. With more of the currency in circulation, each unit is worth less. While modest amounts of inflation are relatively harmless, uncontrolled devaluation can dramatically erode the purchasing power of consumers. If inflation reaches 5% annually, each individual’s savings, assuming it doesn’t accrue substantial interest, is worth 5% less than it was the previous year. Naturally, it becomes harder to maintain the same standard of living.

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