Currency is more than just dollars and cents.
Money runs our world. While it might not directly buy happiness, it buys us the freedom to pursue what makes us happy. No matter how you use it or how you invest it, every good or service, every investment vehicle, or even how we value ourselves, our achievements, and our station among our peers is predicated by our understanding of currency as a physical (or in some cases digital) entity.
Though our goal is to help people develop the best tax-free retirement plans for their future, knowing how to leverage this knowledge becomes much easier by understanding currency. In this article, we’ll explore the importance of currency and some common types, and clarify some common misconceptions – such as the difference between central bank digital currency and cryptocurrencies.
Why is Knowing About Currency Important?
Currency is the most basic component of our goods-and-services-based existence. Money acts as a value voucher where you give someone money for the thing you want and the amount of money that’s exchanged is based on the value of the wanted object. That value is based on various factors such as scarcity, inflation, convenience, demand, and even individual sentimental value (for instance, a huge fan of Prince would pay much more for an autographed album cover than someone who’s indifferent to the late musician or his music).
Just as each country or – in the case of the European Union – economic zone has its own currency, there are different types of currency overall. Not just paper money, but digital currency, cryptocurrency, and other financial instruments. Moreover, the value of a specific currency determines how useful it is, from a person buying groceries to countries negotiating international trade. As our world has sped up largely in part through technology and the Internet, so too have value fluctuations as information, goods, and services move much faster than they did 50 years ago.
While it’s enough to make an accomplished economist’s head spin, money is summed up simply as desire. The more something costs, the more you must desire it to justify that cost – or, conversely, decide something’s not worth the money. By understanding money in the context of human behavior (yours included), you give yourself much more control and clarity amid financial chaos, especially since modern currency mostly relies on trust and confidence.
Basic Currency Terms
Regardless if you prefer dollars, euros, yuan, rupees, or rubles, there are different types of currencies beyond just what a certain nation prints. For instance, you have Bitcoin and Ethereum as cryptocurrencies, as well as countries attempting to make a centralized digital currency that might not be the same as their physical money.
The following are a few of the most common types of currency:
Commodity-Backed Currency
As the name implies, commodity-backed currency is a system where a nation’s currency is backed by some sort of physical commodity, usually precious metals. These also might be referred to as representative monies or currencies, as their value is represented by the commodity that backs them. The issuing government will then guarantee the value of the currency, allowing its exchange for a specified amount of the commodity and, in turn, giving the currency tangible value. Some examples of this include the gold and silver standards, allowing currencies to be converted into their respective metals.
As of 2023, there are no currencies that are backed by gold, though this used to be much more common in the past before the advent of fiat currency.
Fiat Currency
Instead of being backed by a physical commodity like gold or silver, fiat currency derives its value from the faith, trust, and confidence of the people (and governments) who use it. Its stability and value rely on an issuing government’s ability to maintain economic stability, control inflation, and preserve trust in the currency’s use. Some other factors may include the value of natural resources within a country’s borders such as metals, fertile land, oil and natural gas, among others. While none of these directly back the currency in question, foreign demand for access to these resources through trade can affect the value of a government’s fiat currency.
Fiat currency is the most common currency today and can be used in both physical and electronic transactions.
Central Bank Digital Currency
While digital currency can refer to any virtual currency including cryptocurrency, central bank digital currencies (or CBDCs) are centralized digital currencies that exist solely in an electronic form and are issued and regulated by a central authority such as a government entity. Like fiat currency, it’s backed by trust and confidence in the issuing authority. However, given their digital-only existence, CBDCs use infrastructure such as a blockchain or distributed ledger to improve transparency, security, and transaction efficiency.
Many countries have been experimenting with CBDCs to varying degrees, especially post-COVID, where physical cash transactions have been dwarfed by digital ones. It’s important to note, however, that there are also ethical implications that experts are figuring out, especially regarding privacy and or vulnerability to cyber warfare.
Cryptocurrency
Much like CBDCs, cryptocurrencies are a form of virtual currency that uses digital infrastructure, such as a blockchain, and exist solely in a digital form. Unlike CBDCs, however, cryptocurrencies are decentralized and are not issued or regulated by a government or central bank. While their value is also based on the trust and confidence of their users within the network as well as their scarcity and utility compared to other cryptocurrencies, the lack of regulation and the ebb and flow of their popularity causes the value of these currencies to whip wildly in both directions.
Cryptocurrencies aren’t considered legal tender, but they have been acknowledged in some form by the majority of the world’s governments. For instance, different states within the U.S. have various regulations regarding specific cryptocurrencies and their use. In contrast, some countries like China have banned private cryptocurrencies in favor of a government-regulated CBDC. Despite any controversy surrounding cryptocurrency, it’s provided inspiration for many CBDCs whose issuing governments are trying to create digital currencies that are much more stable and trustworthy.
Making the Most of Currency Knowledge with Smart Life Financial
By knowing these types of currencies, you can better understand how they affect different investments. For instance, investment vehicles that rely on fiat currency are at the whim of public trust, both in the currency’s issuing government as well as the company the vehicle represents, such as corporate stock or ETFs. Currencies themselves can be used as a form of investment through foreign exchange, leveraging one country’s money against another and making a profit off of favorable exchange rates.
No matter your preferred investment methods or goals you have, the experts at Smart Life Financial are happy to help develop financial strategies with you. Reach out to us today to learn more about how.
