Currencies
A currency is the official means of exchange used within country or across national boundaries to facilitate the exchange of goods. Most countries also have special types of currency, such as reserve and local currencies. Reserve currencies in particular are important, as they allow a central bank to influence their exchange rate.
National Currencies
Currency is often split into a main unit and a fraction. In the UK, the main currency unit is the pound, and the fraction is pence. In some countries a fraction unit does not exist, for example the Icelandic kr?na cannot be split into smaller parts.
The International Organisation for Standardization (ISO) uses a three letter system for the names of currencies. Several countries use the same name for a currency – the dollar is a commonly named currency in many countries including America and Canada. The ISO code for the British pound is GBP, and the US dollar is USD.
Central Banks
Central banks control the distribution and production of currency, as well as holding reserve currencies. In England the central bank is the Bank of England, and in the USA it is the Federal Reserve. The Euro is managed by the European Central Bank which is based in Frankfurt, Germany.
Currency Trading
In the past, currency trading was not as prominent as it is today. Exchange rates between countries were fixed in price according to how much gold it could be exchanged for. This system, known as the ‘Gold Standard’, collapsed due to concerns about the amount of gold reserves, and today the value of a currency rises and falls depending upon supply and demand.
Reserve Currency
Reserve currencies are major currencies from other countries (mainly the US Dollar) which are held in large quantities by governments or a central bank. They can be used to influence exchange rates. Foreign currency reserves are the amount of reserve currency held by a central bank.
Reserve currencies can be used as a guarantee if a country has a large amount of foreign debt. Large foreign currency reserves gives confidence to other nations that the country will be able to pay their debts.
Reserve currencies can be used to pay foreign debt and influence exchange rates. A country can sell its reserve currency to buy back their currency. The increased demand on their currency increases its value.
Reserve Currency Limitations
It is important to note, however, that foreign currency reserves cannot always be used to change an exchange rate, as other factors such as a lack of confidence in a country’s economic strength or political leadership can cause currencies can fall in value regardless of the efforts of the central banks. This can lead to a country losing money vainly trying to protect the value of their currency, as they sell their reserve currencies for a lower price than they originally bought it.
Currency reserves can also cause a country to lose money even if they do not sell. The value of the reserve currency can drop, and then, of course, it is worth less than what was originally paid. This is particularly a problem if the value of the dollar declines, as the US dollar is the most common reserve currency.
Other Common Reserve Currencies
The Euro is second most common reserve currency. Previous to 1999, the Deutsche Mark was the second most common reserve currency. In 1999 the Euro was introduced in 16 countries in Europe, and took the Deutsche Mark’s place as a reserve currency.
The British pound is the third most common reserve currency. The Pound was a much more common reserve currency in the past; however the economic cost of the two world wars and the dominance of the USA led to a decline in its status.
Local Currencies
Local currencies are a currency not backed by a central government, and can only be used in trade in a small area. An example is the Lewes Pound of Lewes in Surrey, England. This local currency has the same value as British Pound Sterling. It was introduced to help encourage consumers to support the local economy rather than larger chain stores.