What Is Currency? How It Works, and How It Relates to Money

In the upcoming chapters, we will focus on the following topics: 

• Currencies and currency trading 
• Understanding Commodities 
• Interest Rate Futures

Each of these topics is vast, and in India, we are still at a very early stage when it comes to trading these alternate assets.

Coming back to currencies, we will discuss the popular currency pairs that are traded in India. It includes USD-INR, GBP-INR, and INR-JPY. We will also talk about EUR-USD, GBP-USD, and USD-JPY.

Here, 

INR- Indian Rupee

USD- United States Dollar

GBP- British Pound Sterling

JPY- Japanese Yen 

The upcoming chapters will aim to introduce these currency pairs and familiarise the contract specification and a few fundamental factors that affect these currencies.

After currencies, we will try and understand more about commodities. After introducing commodities, we will delve deep into the contrast specifications and the fundamental factors that influence the movement of the commodity. The commodities we will discuss are Gold, Silver, Zinc, Aluminium, Crude oil, Natural Gas, Turmeric, Cardamom, Pepper, Cotton, etc. The formula to calculate the price of gold in the international market will also be discussed. 

In the end, we will discuss the ‘Interest Rate Futures (IFR). The discussion would centre on issues about the RBI’s borrowing habits, the issuing of sovereign bonds, their listing on the NSE, and ultimately their trading.

Here’s everything you need to know about the history of currency: 

1.   The Barter System era 

Prior to the invention of money, trade was conducted using a system known as the ‘barter system’. This system has been around for many years. Typically, in a barter, people trade one good for another (or services). A typical scenario would be if a farmer had gathered cotton and was able to trade (or barter) it for wheat from another farmer. Similarly, a farmer with oranges could sell the oranges to someone who would wash his sheep and cows.

The scale and divisional nature of the barter system was a problem.

The magnitude and divisional nature of the barter system were an issue. For instance, if a farmer had 5 bales of cotton and wanted to exchange them with someone selling cattle, he would end up with 2 cows and a bale of cotton after the barter. Without a doubt, he wouldn’t get a half-cow for a single cotton bale. Within the system, this led to a problem with divisibility.

The barter system’s scalability was another problem because it forced our farmer to travel across the nation with all of his produce to trade for his chosen commodities.

Both these issues- scale and divisibility- were solved with another system known as goods for metal. 

1.   Goods for Metal 

The issues with the barter system finally made room for the subsequent transactional approach. People tried to devise a universal term for the ‘exchange.’ Metals and grains were among the common elements. However, metals eventually flourished for apparent reasons. Metal was easily mobile, divisible, and had more shelf life. 

Additionally, Gold and Silver were the most widely used metals. As a result, these metals soon took over as the norm for transactions. For many years, gold and silver were directly exchanged for products. However, things began to change when people began to store gold and silver coins in safe havens and issue ‘papers’ against the worth of gold. The value of the paper was based on the gold/silver coins deposited in haven.

These safe havens turned into banks as time passed, and paper became currencies. Perhaps, this marked the beginning of the monetary system’s book-entry process.

1.   The Gold Standard 

Over time, domestic and international trade flourished as merchants realised that it didn’t make sense to produce everything locally. This is how imports and export thrived. 

However, merchants had to deal with another country’s currency if they were trading with that country. This is how, in the late 19th century, goods were exchanged for gold, not silver. 

The “Gold Standard” involved comparing the value of the local currency to the price of gold.

As time passed, both the global economic condition and the geopolitical situation (world wars, civil wars, cold wars, etc.) changed. Merchants had a pressing need to evaluate their currency against another currency when undertaking cross-border transactions. The ‘Bretton Woods System’ or the BWS, then entered the scene at this point.

The BWS created a collective international currency exchange regime based on the U.S. dollar and gold.

Countries agreed to use this system with a 1% margin of error on either side (against the pegged value). Since the USD was backed by gold with the BWS in place, it goes without saying that the USD became the currency used worldwide!

The BWS was a method of defining the monetary relationships between nations, where the value of the USD was benchmarked against the price of gold, and the currencies were linked to the USD at a predetermined rate. Countries agreed to use this system with a 1% margin of error on either side (against the pegged value). Since the USD was backed by gold with the BWS in place, it goes without saying that the USD became the currency used worldwide! As developed nations gradually left the BWS system, it eventually disappeared. Countries embraced a more market-driven strategy in which the market determined the value of one currency in relation to another. The market determines the value of currencies based on a nation’s political and economic circumstances compared to the other.