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In economics and finance, currency refers to paper money and coins that represent the monetary base of a country. Currency is a form of money, which is used primarily as a medium of exchange. In international economics, the word currency is used mostly as a reference to foreign currency, the monetary unit of a foreign country.
Currency developed because of the need for a unit of exchange that would be portable, nonperishable, and easily divisible. It appeared with a shift from commodity money to coins made out of precious metals. Currency further developed into fiat money, money that carries no intrinsic value, such as coins made out of nonprecious metals and banknotes, the paper money that is used in most countries today. In the form of fiat money, currency’s value is based on the universal acceptance of the currency for payments. For a given level of a country’s output, the more currency that is in circulation, the higher would be the level of prices in the country.
Many countries have their own national currency, such as the dollar in the United States. There are some countries, however, that do not have their own currency. Economists separate the latter into two groups: those that belong to a common currency area, and those that simply use foreign currency for transactions in their countries. An example of a common currency area is the European Monetary Union. The members of the European Monetary Union all use the same currency, the euro. Countries and regions that use foreign currency are Panama, Ecuador, and El Salvador, which use the U.S. dollar; Kosovo and Montenegro, which use the euro; and small countries and island nations that use the currencies of their closest neighbors or the country that had formerly governed them as a protectorate. Such economies are referred to as dollarized, even if the currency they use is not called “the dollar.”
The amount of currency in circulation is determined by the monetary authority of the country and represents one of the instruments of the country’s monetary policy. In the United States, the monetary authority is the Federal Reserve System. In the European Monetary Union, the European Central Bank, which includes representatives from all the member countries, determines the amount of currency in circulation. Dollarized countries cannot influence the amount of currency in circulation and therefore do not have an independent monetary policy.
Should each country have its own currency? This question, first analyzed in modern economics literature by Robert Mundell (1961), has been the subject of heated debate ever since. Mundell’s theory suggests that two countries should have a common currency if monetary efficiency gain outweighs economic stability loss from having a common currency. This will more likely be the case if the two countries are closely integrated through trade, capital, and labor mobility. Many economists believe that the European Monetary Union is not an optimum currency area because the economies that represent it are too diverse and are not sufficiently integrated. On the other hand, most economists agree that the United States is an optimum currency area, and that it would be costly for each state to use its own currency. Some believe that the world can benefit from the introduction of the single global currency, but most economists think it is not a good idea because independent monetary policy is important to stabilize both real goods and asset markets in conjunction with fiscal policy.
- Mundell, Robert. 1961. A Theory of Optimum Currency Area. The American Economic Review 51 (4): 657–665.
- Single Global Currency Association. http://www.singleglobalcurrency.org/.
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