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Thursday, 5 July 2012

Foreign exchange is not a monetary item


Foreign exchange is not a monetary item

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A foreign currency is not a monetary item since its real value is not affected by local inflation and deflation. A unit of foreign currency is not a monetary item in the local economy because it is not a unit of local currency held or an item with an underlying monetary nature being a substitute for a unit of internal currency held in the local economy.

Money has three functions:

1 Unstable medium of exchange

2 Unstable store of value

3 Unstable unit of account

The local currency is the monetary unit in the local economy. A foreign currency like the US Dollar or the Euro is generally a medium of exchange in any economy outside the US and the European Monetary Union, respectively. Most businesses and individuals would accept the US Dollar or the Euro as a means of payment; that is, as a medium of exchange because they normally can easily exchange the foreign currency amounts they would receive in transactions at their local banks for local currency.

A relatively stable foreign currency is also a store of value in a foreign economy. The US Dollar and the Euro are foreign currencies with daily changing market values in economies outside the US and the EMU respectively. They are generally accepted world–wide as a relatively stable store of value. People know there are normal daily small changes in their foreign exchange values.

The USD and the Euro are, however, not national units of account in non-dollarized economies outside the US and EMU, respectively. You do not normally do your accounting in US Dollars or Euros for tax purposes during low inflation and deflation in non-dollarized economies outside the US and EMU, respectively. You normally do your accounting in local currency values during low inflation and deflation in non-dollarized economies. The USD and the Euro are not functional currencies in non-dollarized economies outside the US and EMU, respectively. A foreign currency like the USD or the Euro is only a medium of exchange and a store of value in non-dollarized economies outside the US and EMU, respectively. Their real values are not affected by local inflation outside the US and EMU, respectively. They are not monetary items in non-dollarized economies outside the US and EMU, respectively.

Foreign currencies are variable real value non–monetary items. They have variable real values which are determined in the foreign exchange markets daily.

The US Dollar, for example, is only a functional currency outside the United States of America in countries like Ecuador, Panama and Zimbabwe which have dollarized their economies. They use the US Dollar as their functional currency. They do not have their own local currencies.

It just appears very strange to say that the US Dollar or the Euro is not a monetary item in SA, for example. Theoretically speaking that is correct because an economic item is only a monetary item in a non–dollarized economy when it is affected by local inflation. The Euro is only a monetary item within the European Monetary Union (EMU) and the USD is only a monetary item within the US economy. The real value of the US Dollar in the US is only affected by US inflation.

The man and woman in the street, however, regard anything that is a medium of exchange as ‘money’ in very limited applications. Cigarettes are often used as a medium of exchange in prisons. Shells have been used way back in history as a medium of exchange.

The man and woman in the street in SA certainly regard the USD and the Euro as money in SA. Foreign exchange would be classified within the SA economy as a variable real value non–monetary item stated at its current market value (today) and not the same as the SA Rand, that is, not as a monetary item under financial capital maintenance in units of constant purchasing power (CIPPA).

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Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.