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Currencies - Basic information

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A long time ago, barter trade was replaced by implementing currencies into daily human lives. That trend lasted for thousands of years into modern society, where currencies are still used to facilitate the exchange of goods and services. Generally, currencies have two distinctive features: they are issued by the government and accepted as general means of payment. In the past, currencies took predominantly the form of coins and paper notes. However, the rise of computer technology brought a new virtual form of money. Additionally, it led to even more interconnected relationships between currency pairs in the scope of the global forex market. 

 

Key takeaways:

  • Currencies are used as a means of payment.
  • The forex market is made up of currency pairs.
  • Currencies are strongly influenced by supply and demand dynamics.
  • Fiat money is not backed by anything.
  • The currency market is highly liquid and complex.
  • The forex trading is dominated by high-frequency trading.

 

Money and fiat currencies

The terms “fiat currency” and “money” are often used interchangeably. However, some economists like to draw distinctions between these two terms. Fiat currency is commonly issued by a government and is not backed by anything. Because of that, the value of a fiat currency is determined by the relationship between its supply and demand. In the past, some economies preferred to tie the value of their currency to a commodity. Commodities used for this purpose were, for example, gold, silver, oil, or rice. Nevertheless, gold proved to be the most widely used in the past. Eventually, this gave birth to the gold standard, a monetary system that ties the value of a currency to gold. Therefore, some economists refer to gold as “money” and currencies as “fiat.”

 

Foreign exchange market

The foreign exchange market, also called forex, is the biggest financial market in the world. It comprises individual investors, private and public companies, central and commercial banks, hedge funds, etc. It can be divided into the interbank level and over-the-counter level. Big banks and financial institutions trade on the interbank level, while individual investors trade over-the-counter (OTC) through brokers and trading platforms. The forex market allows its participants to hedge risk, diversify portfolios, and speculate on currency rates. The forex market is a complex system consisting of a worldwide network of financial institutions rather than a single financial entity.

 

Money supply M0, M1, M2

The money supply has three main components: M0, M1, and M2. The first component, M0, also called the monetary base, includes all physical cash in circulation and the central bank's reserves. M1 consists of M0, demand deposits, checking accounts, and other liquid assets that can be quickly converted to cash. Meanwhile, M2 encompasses M0 and M1 while also including different types of deposits, money market securities, and other assets deemed less liquid than those in M1. 

 

The most widely used currencies

  • Euro (EUR)
  • U.S. dollar (USD)
  • Chinese yuan (CNY)
  • Japanese yen (YEN)
  • British pound (GBP)
  • Australian dollar (AUD)
  • Swiss franc (CHF)
  • Mexican peso (MXN)
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