Currency Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The term currency generally refers to the official means and regulations of payment of a country or region, which have been legally introduced and which are accepted (by law) as a compensation for goods and services. Currency includes banknotes and coins and represents a sub-category of money. Money refers to all means of exchange, also gold, whiskey, tobacco, and other commodities. Currencies, however, are means of payment that are produced and regulated by the government and do not represent goods on their own. Their intrinsic value (i.e., the physical value of a currency) does not coincide with its traded value.

The production and issuance of currencies is, in most cases, incumbent on national central banks or a single central bank for a certain currency zone, such as the European Central Bank, which is responsible for the European Monetary Union. Such institutions regulate the money supply in order to guarantee price stability and, thus, avoid inflation.

Today, about 160 different currencies exist which have, according to their name, an ISO 4217 currency code consisting of three alphabetical letters. They are used in international trade, e.g., EUR for the euro or USD for U.S. dollar. In order to buy goods from any other society it may be necessary to have foreign currency. Therefore, currencies can also be subject to trade and the value of one currency in terms of another currency is expressed by the exchange rate. For international trade, very often leading currencies (i.e., currencies that are preferably used in cross-border transactions) are chosen. They can be easily traded internationally and are often chosen to lock out the exchange rate risk, because they are considered more stable than other currencies. Such leading currencies include, among others, the U.S. dollar, the euro, the yen, the pound sterling and the Swiss franc.

Functions And Characteristics

A currency fulfills three main functions: medium of exchange, unit of account, and store of value. As a medium of exchange, a currency allows its holder to exchange it for any good or service that he or she requires. That is, the seller of a product is not confined by the products of his clients, as would be the case in barter transactions, where goods and services are exchanged without money. Therefore, currencies give their owners more flexibility. It is necessary that people trust in a currency as a medium of exchange, i.e., that they can reliably exchange it for other goods or services. This is of special importance if the traded value of the currency does not reflect the real value of the material that the currency is made of; for example, banknotes may indicate a higher value (printed on the surface) than their real, physical value (i.e., the value of the paper) represents. In order to guarantee that the nominal value of a banknote equals the real value of goods and services, its issuer has to hold reserves of commodities (such as gold) that guarantee the nominal value. In case of inflation (i.e., a decrease in the value of a currency), market agents may lose their trust in a certain currency and shift to barter transactions to exclude the risk of a devaluing currency.

Currencies, as a unit of account, also facilitate the comparison of unequal goods or services. It may seem difficult to compare a haircut (a service) with a new notebook (a commodity) without having a value of reference. By indicating how much of a currency is needed to buy a haircut and a notebook, it is possible to easily compare these commodities with each other. In addition, this also allows the comparison between countries by using the exchange rate, e.g., how much does a certain notebook cost in country A and how much in country B. Currencies as a unit of account also facilitate the comparison of productivity and success of companies across industries and countries.

Finally, currencies allow their owner to store value for future consumption. In comparison to goods, such as fish or vegetables, currencies are more durable and therefore save value. Historically speaking, however, periods of inflation and deflation have shown that the real value of a currency can considerably be altered, which relativizes this function. Still, the advantages of currencies outweigh other media of exchange or units of account. Currencies also allow the establishment of more complex credit systems, where those who need value to buy certain assets can borrow money from those who have stored it for future consumption. This again improves the efficiency of an economy as money can more optimally be allocated by its participants, in line with their wants and needs.

In order to fulfill all these functions, a currency has to have certain characteristics. A good currency is easy to recognize and can be easily distinguished from other assets. This is definitely true for gold, due to its unique luster, color, and weight. Regarding banknotes and coins, they are unique, because they have special imprints and embossments. Apart from that, they also include several copy protections. It is also important that a currency is divisible and portable. On the one hand, if gold is used as a currency, it can be simply cut into pieces without destroying the value of the broken parts as they reflect their implicit value. As far as banknotes and coins are concerned, there are several subunits of them, indicating different values printed on their surfaces, which do not represent their real value (see above). On the other hand, the transportation of a currency should be easy, thus increasing the its flexibility and circulation. Finally, it is crucial that a currency is durable. This is necessary to fulfill the function of storage of value as explained above. Today, the use of electronic transactions and electronic credit cards, instead of a physical exchange of currencies for goods or services, makes these characteristics nearly obsolete. Also, bank accounts are denominated in currencies and not in goods or services.

Currency And The Economy

The introduction of a currency facilitates international and international trade considerably. David Ricardo’s theory of comparative advantage postulates that countries, companies, and individuals should specialize in the production of certain goods or services in order to realize gains from trade. However, this indicates that agents have to buy several other goods or services in order to survive, as they specialize in producing only one particular product and not everything they may need. In simple economies, barter may be eligible, but costs of trade will increase due to higher transportation costs, thus making products more expensive. In more complex economies, trade that is solely based on barter transactions is almost impossible.

Due to the three functions of currencies (see above) it is not necessary to triangulate transactions, i.e., individual A wants to buy goods from individual B, who is only prepared to exchange products for those of individual C, who him/herself needs products from individual A. As a consequence, currencies even speed up trade and reduce the number of transports as the purchase and sale of goods or services can be separated from each other. This increases efficiency in trade and transaction costs can be cut severely.

Currency Crises

The pressure on global financial markets in the 1990s caused several currency crises. Examples include the Czech Republic crisis in 1997 and the Russian crisis in 1998, which harmed their economy severely. It is worth mentioning that both crises had been triggered by different economic variables. On the one hand, the Czech currency crisis was characterized by a deterioration of macroeconomic fundamentals and political instability, appearance of a speculative attack, an effort to defend the koruna, and finally a depreciation and change in the exchange rate regime from a fixed to a floating one. On the other hand, the crisis in Russia can be seen as the consequence of its fragile and vulnerable economic and political fundamentals and massive capital flight.

So far, three different prevailing models aim at explaining how currency crises come into existence and which variables best describe or even predict them. Krugman’s model, developed in 1979, is generally known as the traditional approach concerning currency crises. It is based on balance of payments problems, reflected by a steady but slow reduction in international reserves, in a country with a pegged currency. According to this model, the expansion of domestic credits to finance fiscal deficits or improve a weakening banking system and the increase of money demand reduce international reserves and consequently results in a speculative attack that would force authorities to abandon their fixed exchange rate regime. In following years, Krugman’s model was extended by other studies and showed that a real appreciation of a currency often precedes a speculative attack. In addition, domestic interest rates increase if a currency crash is at hand. To sum up, the first-generation models focus on expansionary macroeconomic measures undertaken by a country with a fixed exchange rate regime and therefore are said to be predictable.

Second-generation models refer to countercyclical government policies and take into account uncertainties and features of speculative attacks. Currency crises are also defined as changes from one monetary policy equilibrium to another, caused by self-fulfilling speculative attacks. For example, agents believe that currency A will lose its value in the near future and therefore exchange it for a more stable one. Therefore, the demand for currency A decreases and, as a consequence, its value does as well. The interaction of economic policies and economic agents could allow jumps between multiple equilibria without having an impact on fundamentals. Thus, an economy with a fixed exchange rate regime could find itself in equilibrium, but a turn in expectations of economic agents could trigger policy measures, which cause a breakdown of the exchange rate regime. In other words, speculative attacks are independent of the consistency between the currency policy and an exchange rate fixing. In short, second-generation models imply that currency crashes are far more difficult to predict, but economic fundamentals are still of importance, although there is no strong relation between these indicators and a possible crisis.

While second-generation models assume that all speculators know about each others’ intentions, third generation models eliminate this unlikely assumption in arguing that fundamentals can only be monitored with noise. Moreover, the amount of noise in a signal may vary between speculators, but at the same time results in a new equilibrium. Furthermore it is concluded that economic fundamentals might not signal an upcoming crisis, like in second-generation models, but speculators would still attack the currency, due to the uncertainty of expectations of other economic agents. Apart from that, third-generation models are based on structural weaknesses, e.g., foreign currency debt exposure in the corporate and financial sector. Finally, these models are characterized by moral hazard, imperfect information, and the exorbitant upend downturns in international lending and asset pricing.

In view of the above, currency crises can be considered to be diverse in their nature and, as a consequence, in their origination. Very often currency crises accompany or are accompanied by banking crises.

Bibliography:

Irving Fisher, The Purchasing Power of Money: Its Determination and Relation to Credit Interest and Crises (Gardners Books, 2007);
International Organization of Standardization, ISO 4217, www.iso.org (cited March 2009);
L. Kaminsky, “Currency Crises: Are They All the Same?” Journal of International Money and Finance (v.25, 2006);
L. Kaminsky, S. Lizondo, and C. M. Reinhart, “Leading Indicators of Currency Crises,” IMF 79 (1997);
Krugman, “A Model of Balance-of-Payments Crises,” Journal of Money, Credit, and Banking (v.11/3, 1979);
Allan H. Meltzer, A History of the Federal Reserve (University of Chicago Press, 2003);
Emilie Rutledge, Monetary Union in the Gulf: Prospects for a Single Currency in the Arabian Peninsula (Routledge, 2009);
Schardax, “An Early Warning Model for Currency Crises in Central and Eastern Europe,” Focus on Transition 1 (OeNB, 2002);
J. G. Vlaar, “Currency Crisis Models for Emerging Markets,” DNB Research Reports, Research Memorandum WO&E (n.595/9928, 2000).

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