I happened to travel on a train for one full day and I had a wonderful experience to talk with an economist. Some people were discussing the free fall of rupee against the dollar and then, the old lady sitting opposite my seat explained some evolution of trading system to make the concept clear to all the co-passengers. Below are some excerpts from the discussion.
In olden days when there was no currency people used to barter the commodities and services. By bartering I mean that doing some service in exchange of a service or giving some commodity in exchange of a commodity i.e. wheat for rice or vice versa. The most common commodities at that time were spices, grains, salt, cattle, seed, tobacco and tea. There were two major problems with this trading system first one it was difficult to get something without giving a commodity in exchange so everyone had to carry bags full of salt or grains. Second problem was to negotiate on the quantity of different goods in exchange of a good like how much salt for a bag full of 20 Kgs of rice. This is not as simple as it seems to be as there are multiple vendors/suppliers of the same commodity. So, people resolved to have a common trading instrument in exchange of the goods. Which in modern days we call as currency.
Initially the currency was made up of metals, as it was easy to carry and reusable. Since coins were having specific value on it, it became easier to trade the commodities. When the coins or the metal of the coin itself became a commodity then people had to resolve to other instruments and this time they resolved to paper currency. The first paper currency note dates back to AD 960 and was used by China.
This seems simple right? No, it gets complex when the circle of trade increased from one locality to state to country and then Global. Things become pretty complex when there are two countries involved in the trade where two different currencies are involved. Now the challenge is how to compare one currency against another currency. The value of currency is decided by the price in foreign exchange market. Every country through a centralized body that regulates the value of its currency, for India this is done by RBI (Reserve Bank of India). A currency will become more valuable if the demand for the currency is more than available supply and demand of a currency increases if the country is exporting more items then it imports. Currently India is not doing well in exports; rather we are importing lot of commodities that is making our currency weaker and dollar stronger. There are other reasons that explain the depreciation of a currency like Inflation, current account deficit, differences in Interest rates, public debt and political stability.