2) Most currency today is fiat currency, meaning that it is implicitly backed by the strength of the issuing nation's economy rather than by stores of gold or goods. Currency is used to facilitate financial transactions between parties. The value of the currency is determined by the trade of the nation relative to other nations. Settling that trade requires a system wherein currency values are stabilized.
Gold was once the official reserve asset, but today foreign exchange assets serve as reserves. The United States, for example, holds Euros and yen as its foreign exchange assets while many other countries hold dollars. These reserves are recognized for payment between governments.
Governments hold reserves as a means of ensuring the stability of their own currency. The foreign exchange reserves increase or decrease on the basis of the balance of trade. So for example China has a trade surplus, and this can allowed it to accumulate substantial foreign exchange reserves, particularly dollar assets. These dollar assets are indicative of China's economic strength. Likewise, the U.S. stockpile of Euros and yen indicates America's trade position.
The current account balance reflects a country's standing with respect to foreign exchange reserves. The United States, for example, can build a current account deficit by selling U.S. treasuries to central governments overseas to hold as foreign exchange assets. Nations hold each other's assets as a means of settling trade debt. Canada typically has a trade surplus and uses its foreign assets as a mean to make payments on its foreign debt.
Nations use sovereign debt as a means of moving money between each other. Countries...
As a result, the U.S. issues treasuries and these are purchased by the Chinese to hold. By this means, the U.S. can effectively recognize the obligations that it has accrued to China as a result of the disequilibrium in the trade between the two countries.
The current system of international currency payments is what facilitates global trade. Currency values accurately reflect the underlying wealth of a nation. Countries are able to issue and settle debt in relatively liquid markets. Currency flows between nations are also transparent, in the form of debt issues and are recorded in the balance of payments statistics. Because of these attributes, this system has allowed international trade to flourish. Better information and transparency have delivered trust in the international currency markets.
The main conclusion that can be drawn is that currency values today are the result of underlying economic activity. Within nations, firms trade with one another in a direct exchange of capital. To settle overall trade discrepancies, nations trade stocks of each other's currency with one another. These stocks can be used to settle other debts, or they can become a part of the nation's stock of foreign exchange reserves. These reserves can be held and then used to pay down debts in the future. They are also used to stabilize the value of the holding nation's currency, as they are one measure of economic activity. The system is liquid and transparent, which allows international trade to flourish free from the negative externalities and questionable information that characterized international trade prior to the current system.
