How Currency Works

­Currency, or money (we'll use the terms interchangeably for the purposes of this discussion), can be defined as a unit of purchasing power. It is a medium of exchange, a substitute for goods or services. It doesn't have to be the coins or bills with which you're probably most familiar. In fact, through the ages, everything from large stone wheels, knives, slabs of salt, and even human beings have been used as money. Anything that people agree represents value is currency.

For example, if you have one barrel of wheat, and you want a cow, without currency you have to find someone who not only has a cow, but also wants a barrel of wheat and will agree to the trade.

Let's say your neighbor fits the bill -- he has a cow and wants a barrel of wheat. What if a barrel of wheat isn't worth an entire cow? Your neighbor can't exactly make change by giving you part of a cow.

Now, if you live in a place where round, stamped coins are widely considered to have a certain value and can be exchanged for other things, then you just have to find someone who needs wheat. That person will take the wheat in exchange for an agreed-upon amount of coins, which you can later use to buy a cow from someone else.

This is not to mention the fact that carrying a handful of coins is much easier than lugging around a barrel of grain or a cow with you whenever you need to make a trade.

Besides serving as a substitute in trades, money's other important use is as a store of wealth. In a straight barter system, the commodities being traded are generally perishable. You can gather tons and tons of wheat by making shrewd trade deals, but if you try to save the wheat, it will eventually go bad. Money allows people to accumulate wealth.

This had an enormous impact on civilization, because it meant that power wouldn't always be passed through families. People who had been excluded from any possibility of holding political power could amass wealth through trade or by providing a service. That wealth could then be used to purchase political or even military power. So money made civilization more democratic by taking some power out of the hands of noble families that had monopolized it for hundreds of years.

The forms and functions of currency have changed over the last 3,000 years or so, generally falling into four categories:

Commodity Currency

The development of commodity-based currency systems represents more of a blurring between barter systems and later currency systems than a revolutionary change. In a commodity system, the money used is not only a "place-holder" for purchasing power, but it is something that has an inherent value by itself.

A good example of a commodity system is the one used by the Aztecs. They placed great value on cacao beans, which could be used to make chocolate. The beans were small and easy to carry, so they were often used to balance out or make change in barter agreements.

The benefit of commodity money, according to anthropologist Jack Weatherford, is that, "unlike paper money and cheap coins that can easily lose their face value, commodity money has a value in and of itself and thus can always be consumed no matter what the status of the market."

There are still drawbacks to commodity money. It is often perishable and bulky. Cattle were used frequently as commodity currency in agrarian societies. They worked well as a medium of trade, because everyone in that society placed value on them but they were hard to transport.

The value of a commodity currency seldom extends beyond the borders of the culture that uses it. If a herder from the country wants to trade with a city dweller, his cattle aren't going to have much value. European explorers dumped entire boatloads of cacao beans because they didn't value them like the Aztecs did.

The first coins were minted in Lydia, an ancient empire in the area of modern Turkey. The Lydian king Croesus started making small metal ingots stamped with an imperial emblem around 640 B.C.

This Lydian custom spread to the Greeks and eventually to the Romans. Coins were usually made of silver or gold, and their value was enforced by the authority of the government that issued them. If the Athenian officials declared that all coins minted in Athens, with the official stamp of Athens, were 97 percent silver, then those coins would be traded at that value.

In China, coins developed at about the same time that they did in the West. In the fifth century, B.C., the Chinese began using a form of commodity currency in the shape of knives or other tools. The metal blades had a round hole at one end, so the money could be strung onto a rod or rope. Eventually, the tools became more stylized. Over the years, they became smaller and smaller, until only the round end with a hole in it was left. These round, pierced Chinese coins remained virtually unchanged until the 1800s.

An important effect of coins was that governments now controlled the release of money into the market. They could also manipulate the money supply. This was done by various Roman emperors, who would reduce the precious metal content of Roman coins when they needed money. They figured that if a ton of gold made 10,000 gold coins, they could have twice as many coins by cutting the gold content in half. Instead of making the emperors richer, the constant devaluation of Roman coins -- and the resulting instability of the Roman economy -- is one of the factors that led to the fall of the Roman Empire.

When Rome fell, most of Europe returned to a more primitive, feudal system of economy. Throughout the Dark Ages, people became distrustful of coins, and that currency fell out of use. Coinage wouldn't return until the Renaissance.

Paper money was developed first by the Chinese, who used stag skins, bark, or parchment marked with the imperial seal as "bills of payment." The penalty for counterfeiting was death.

Paper money had trouble gaining acceptance in Europe. Leather money was used around 1100, but only as a temporary substitute when silver supplies ran low. A Swedish bank issued paper money in 1661, but they eventually flooded the market with it, and it lost its value.

The use of paper money really caught on in Europe in the 1700s, when the official bank of the French government began issuing paper money. The idea came from goldsmiths, who often gave people bills of receipt for their gold. The bills could be exchanged for the gold at a later date. That's an important fact in the development of paper money, because it means that the money represented a real amount of gold or silver that actually existed somewhere. A piece of money was actually a promise from the institution that issued it (either a government or a bank) that the institution would give the holder of the bill a certain amount of gold or silver from its stockpile whenever he wanted it. Under this kind of system, the money is said to be "backed by gold." With a few temporary exceptions, during wars or other emergencies, all currency in the world was backed by a real supply of precious metal until 1971.

Since money is really just a representation of value, it didn't take long for people to realize they could just send information about money by telegraph or other electronic means, and it was just as "real" as sending the money itself. After World War II, banks would record information about the day's transactions onto large magnetic reels, which were taken to the regional Federal Reserve Bank. This system eliminated the need for the large denominations that were printed prior to the war to facilitate these large-scale transfers. Today, the $500, $1,000, $5,000, and $10,000 bills printed during this period are very rare, though some are still in circulation.

Later, wire connections were established between the banks, so the transfer information could be sent directly.

By the early 1990s, all transfers between banks and the Federal Reserve were done electronically.

There are three other important steps in the history of electronic money:

One of the long-standing myths about modern currency is that it is backed by the U.S. gold supply in Fort Knox. That is, you can trade your greenback dollars to the U.S. government for the equivalent amount of gold bullion at any time.

At one point, this was true of most paper currencies in the world. However, the U.S. took away the government backing of the dollar with an actual gold supply (known as leaving the gold standard) in 1971, and every major international currency has followed suit.

The obvious question is, "Without gold, what does guarantee the value of our money?" The answer is: nothing at all.

The only reason a dollar, or a franc, or a Euro has any value is because we have a stable system in which people are known to accept these pieces of paper in return for something valuable. Or, as Nobel Prize-winning economist Milton Friedman puts it, "the pieces of green paper have value because everybody thinks they have value."

Understanding that the value of money is based on our perception of its worth is easier if we look at how that perception can alter the specific amount of that value. Let's say that one American dollar is worth 5 French francs. One day, the U.S. government announces that part of its economic policy will be to allow the value of the U.S dollar to decrease slowly to about 3 francs (the U.S. government might do this to encourage foreign investors, among other reasons). The next day, the value of the dollar would likely drop sharply, which it has in similar situations. Why? The government announcement led people to believe that their dollars would be worth less -- therefore, they were worth less. The same effect can be seen in today's stock market, which is another currency system. When a company declares that its profits are down, the value of the company's shares can drop within minutes.

You may have heard your parents or grandparents talk about how different things were when they were your age. It only cost a nickel to see a movie. Gas was 30 cents per gallon. A brand new car might cost about $5,000. In the intervening years, prices have risen, sometimes drastically. Seeing a movie in the theater now costs about $8; gas can cost more than $2 per gallon in some places; and few new cars cost less than $15,000. That's inflation.

Inflation is when a certain form of currency starts to have less value over time. It is caused mainly by two things: people's perception of value, and the economic principle of supply and demand.

We have already examined some of the ways that people's perceptions of a currency's value can affect its value. This effect causes inflation by directly affecting the value of the money. When currency was still on a gold standard, inflation often happened when people started to worry that the government or bank wouldn't be able to redeem their cash for gold. If you had a dollar that was worth an ounce of gold, but people thought the government only had half of the gold required to redeem it, then dollars would start being traded at a value of half an ounce of gold.

Supply problems have had far more dramatic inflationary effects. Throughout history, governments have tried to solve financial problems by simply printing more money. This can drive the value of money drastically downward, especially in modern markets where money is not backed by gold. Twice as many dollars in an economy makes those dollars worth half as much.

After World War I, Germany was forced to pay war reparations of about $33 billion. It was virtually impossibly for the nation to produce that much actual output, so the government's only choice was to print more and more money, none of which was backed by gold. This resulted in some of the worst inflation ever recorded. By late 1923, it took 42 billion German marks to buy one U.S. cent! It took 726 billion marks to buy something that had cost just one mark in 1919.

The U.S. Bureau of Engraving and Printing currently produces $1, $2, $5, $10, $20, $50, and $100 bills.

$2 bills are printed whenever necessary, and were last printed in 2003. In the 1930s, a series of $100,000 bills were printed, the largest denomination in U.S. history. These bills were used only for transactions between Federal Reserve banks; they were never circulated publicly.

The United States Mint produces coins worth 1, 5, 10, and 25 cents, as well as the Sacagawea Golden Dollar Coin, which replaced the Susan B. Anthony Dollar Coin in 2000.

The U.S. Mint produces nearly 30 billion coins for general circulation each year. The Bureau of Engraving and Printing produces 37 million notes a day with a face value of approximately $696 million. Roughly 95 percent of those notes are made just to replace old notes.

The coins in your pocket and the money in your purse might be something you take for granted. Modern currency is really a complex, worldwide system that we use every day, impacting nearly every aspect of our lives. For more information about currency and coinage, check out the links on the next page.