It comes as no surprise that money plays a critical role in modern day economies, and their functioning a profound impact on all economic activities. However, have you ever wondered how it actually work? How can the value of the US-dollar have more financial significance than other currencies? In this article it will all be explained.
How does money work?
Currencies serve as a medium of exchange, which facilitates all transactions in the economy. They are accepted as a means of payment for goods and services. This eliminates the need for so called “barter systems”, where individuals would have to exchange one good for another. Which was common in hunter gather societies. Currencies provide a standardized unit of measurement for the value of goods and services. This common unit of account simplifies price comparisons and economic calculations. They also store value over time.
This is done by for example, people saving money by holding currencies in various forms (cash or digital) and use them at a later date. However, inflation can erode the purchasing power of money over time.
Currencies enable contracts that involve future payments, such as loans and mortgages. When I was applying for my first mortgage at age 21, I agreed to pay a certain amount of money to the bank in a span of 30 years with interest, with the value of the national currency, which is assumed to remain stable.
How Currencies Affect the Economy:
The amount of currency in circulation and its velocity can influence price levels in the national and sometimes even the global economy. An increase in the money supply can lead to inflation, while decrease can lead to deflation. Central banks, like the Federal Reserve in the United States, monitor and manage these factors to maintain price stability. [1]
Currency values relative to other currencies, known as exchange rates, play a critical role in international trade and investment. For instance, a strong domestic currency like the Euro, can make export more expensive and imports cheaper, potentially affecting trade balances. [2]
Central banks use interest rates as a lever to influence economic activities. Higher interest rates can discourage borrowing and spending, helping to control inflation but potentially slowing economic growth. As we have seen in the United Kingdom. [3]
Currency stability and exchange rate potential influence investment decisions. Investors are attracted to invest in countries with stable currencies and potentially higher returns, which can affect capital flows and economic growth. [4]
Currency values are also subjected to people’s confidence in the currency’s stability and speculative trading activities. News, economic events, and political stability can trigger fluctuations in currency exchange rates as investors and traders respond to changing circumstances, like the war in Ukraine. [5] Simultaneously, government and central bank policies play a vital role in managing currencies. They can intervene in the foreign exchange market, set monetary policies, and implement fiscal measures to achieve specific economic goals. [6]
In conclusion, currencies are essential for economic transactions and are a crucial part of monetary and fiscal policies. Their value, stability, and exchange rates have wide-ranging impacts on economies, including its price levels, international trade, interest rates and overall economic growth.
Sources:
- “Inflation,” Federal Reserve, https://www.federalreserve.gov/faqs/economy_14400.htm
- “Exchange Rates,” Investopedia, https://www.investopedia.com/terms/e/exchangerate.asp
- “How Do Central Banks Control Inflation?” Investopedia, https://www.investopedia.com/articles/04/051904.asp
- “Foreign Exchange Market,” Investopedia, https://www.investopedia.com/terms/forex/f/foreign-exchange-market.asp
- “Currency Speculation,” Investopedia, https://www.investopedia.com/terms/c/currencyspeculation.asp
- “Monetary Policy and the Economy,” Federal Reserve, https://www.federalreserve.gov/monetarypolicy/overview.htm
