Here's the simple version: currency is something we all agree has specific value.
If you had a secret club when you were six and you decided that you would use green M&Ms to buy action figures or your best friend's extra chocolate chip cookie, the green candy was a type of currency, as long as all your friends agreed about the value of M&Ms. Which, duh, they did.
The greenbacks cooling in your wallet are currency, too, but they're way more stable than green M&Ms. For one thing, you're unlikely to eat them. For another, they're guaranteed by the assets of the Federal Reserve Banks. American money is issued by the U.S. government (not Mars, Incorporated, the makers of your favorite candy) and it's the legal means and basis of trade. In other words, if you want to buy action figures from anyone other than a six-year-old, you'll need to use U.S. dollars to do it.
In the U.S., you're expected to pay with U.S. dollars (fancy that), but when you travel, you have to exchange your money for that country's currency. The Japanese have yen, Mexico has pesos, Canada has the Canadian dollar…the list goes on.
In Europe, most countries had their own currencies until 2002, but then the Euro was introduced. The idea was that the Euro would even out the playing field between the really wealthy countries like Britain (the pound sterling was worth a lot) and less wealthy countries like Spain (the peseta was worth less than the British pound, which hurt Spain in trade). What ended up happening? Countries continued to squabble over currency, and in the end, the Euro didn't solve the world's financial problems. (Surprise!)
To keep things really interesting, there's even an electronic currency that has no country basis. Bitcoin is referred to as a decentralized digital currency, a virtual currency, and (our favorite) cryptocurrency. Bitcoin allows for online trade without the need for exchange or conversion between one country's currency and another. It hasn't quite taken off yet, but…you heard it here first.
Investing in Currencies
If you're heading on vacation to France, you're going to have to exchange your American dollars for Euros to pay for stuff on your trip. Your little sister might also collect coins or bills from other countries. You might even try to put a Canadian coin in the pinball machine and see if it works.
But that's not all you can do with currencies.
You can also invest in them—and it works sort of similarly to what happens when you travel.
Let's say you go on that vacation to Paris. Before leaving, you go to a bank and exchange 100 U.S. dollars for 92.58 Euros. In other words, to buy 92.58 Euros you need 100 U.S. dollars (we're assuming your bank didn't charge you any fees for the transaction). But returning home two weeks later, you decide to cash in the 92.58 Euros for U.S. dollars.
This time, though, you're handed $110.
What happened? The exchange rate or the amount of money each currency is worth changes with time. The U.S. dollar will go up one day and drop the next, depending on lots of stuff, like how well the economy is doing, how much debt we have, and how well others think our economy is doing.
This difference in exchange rates and the fact that different currencies are worth different amounts lets you invest.
There are two basic ways to do it:
(1) Open a foreign exchange market (forex) account or work with a forex broker to exchange two currencies. Basically, you're hoping that one currency will increase in price and one will nosedive, making you money on the difference.
(2) Buy certificates of deposit (CDs), foreign mutual funds full of foreign government bonds, or other investments rooted in foreign currencies. You're basically betting that you can buy these investments for cheap and that they will increase in value as a country's economy improves and their currency gets stronger.