How Currency Works

Whether we pull out paper bills or swipe a credit card, most of the transactions we engage in daily use currency. Indeed, money is the lifeblood of economies around the world. To understand why civilized societies have used currency throughout history, it's useful to compare it to the alternative. Imagine you make shoes for a living and need to buy bread to feed your family. You approach the baker and offer a pair of shoes for a specific number of loaves. But as it turns out, he doesn't need shoes at the moment. You're out of luck unless you can find another baker - one who happens to be short on footwear - nearby. 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. There are other important benefits of money, too. The relatively small size of coins and dollar bills makes them relatively simple to transport. Consider a corn grower who would have to load a cart full of food every time he needed to buy something. Additionally, coins and paper have the advantage of lasting a long time, which is something that can't be said for all commodities. A farmer who relies on direct trade, for example, may only have a few weeks before his assets spoil. With money, she can accumulate and store her wealth. Various Forms Today, it's natural to associate currency with coins or paper notes. However, money has taken a number of different forms throughout history. In many early societies, certain commodities became a standard method of payment. Around the 16th century, for example, the Aztecs often used cocoa beans instead of trading goods directly. However, commodities have clear drawbacks in this regard. Depending on their size, they can be hard to carry around from place to place. And in many cases, they have a limited shelf life. These are some of the reasons why minted currency was an important innovation. As far back as 2500 BC, Egyptians created metal rings that they used as money, and actual coins have been around since at least 700 BC, when they were used by a society in modern-day Turkey. Paper money didn't come about until the Tang Dynasty in China, which lasted from 618-907 AD. More recently, technology has enabled an entirely different form of payment: electronic currency. Using a telegraph network, Western Union (NYSE:WU) completed the first electronic money transfer way back in 1871. With the advent of mainframe computers, it became possible for banks to debit or credit each others' accounts without the hassle of moving large sums of cash. Types of Currency So, what exactly gives our modern forms of currency -- whether it's an American dollar or a Japanese yen -- value? Unlike early coins made of precious metals, most of what's minted today doesn't have much intrinsic value. However, it retains its worth for one of two reasons. In the case of "representative money," each coin or note can be exchanged for a fixed amount of a commodity. The dollar fell into this category in the years following World War II, when central banks around the world could pay the U.S. government $35 for an ounce of gold. However, worries about a potential run on America's gold supply led President Nixon to cancel this agreement with countries around the world. By leaving the gold standard, the dollar became what's referred to as "fiat money." In other words, it holds value simply because people have faith that other parties will accept it.

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