What is Currency?

To understand currencies, we need to go back in time and take a dive into our history.  

Before currencies came into the picture, there was something called the “Barter System”. Here, people exchanged goods for other goods. For example, suppose a farmer “A” harvests wheat and wants 1 kg rice. Similarly, another farmer “B” harvests rice and wants 1 kg of wheat in return. The two farmers can exchange goods with each other.

However, the problem with the barter system is scalability, i.e., it is very difficult to measure what the exact quantity of wheat farmer “A” needs to offer that will be equal to 1 kg of rice. Every commodity which is available in the market does not represent the same utility values, meaning a person may desire water more than they desire potato.

Soon people realized the problems with this system and came up with what is known as "the metal era". Here, people exchanged goods for a certain amount of metal which could be gold, silver, etc. This system proved to be better than the barter system, but is not an optimal solution because when people started depositing gold and considered it as a "safe haven currency", it became known as the “paper currency”.

Banks were formed, people started depositing their money in them, different countries started to represent themselves by their currencies. People also started to understand that it is not optimal to produce everything on their own, and, it may be cheaper to import some of the commodities, which also meant that merchants had to pay a currency that was acceptable in terms of the country that they were exporting the goods from. 

In the 1870s, countries agreed to value their currency with other countries using gold as the benchmark for valuation. As per this process, central banks issue paper currency and hold an equivalent amount of gold in their reserves. As countries disagreed on the value of the currencies that the other country had set up, this led to the creation of currency markets, where the markets decide the value of each currency independently.  Therefore, the value of each currency against another is derived from the exchange rate.

To put it simply, when money is branded it is called 'currency'. Each country has its own 'brand'. Whenever there is a cross- border trade, a need to exchange one brand of money for another is developed, and this exchange of currencies is known as "foreign exchange" or "forex".