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Currency value is determined like any other good or service in a market economy – through supply and demand. Factors affecting supply and demand are regulated by the government through monetary and fiscal policy.
Currency value is determined by aggregate supply and demand.
Supply and demand are influenced by a number of factors, including interest rates, inflation, capital flow, and money supply.
The most common method to value currency is through exchange rates. The two main exchange rate systems are fixed rate and floating rate systems.
History of Currency Value
Currency came around several hundreds of years ago as a means to replace the barter system. Early currencies were “commodity money,” meaning they derived intrinsic value from the precious metals they were made of.
However, the impracticality of commodity money created the shift towards “representative money” – money that lacks intrinsic value but is backed by its ability to be traded for a physical commodity. The most notable use of representative money is under the gold standard, where each country’s currency is tied to a fixed amount of gold.
The drawbacks of the gold standard became clear during World War I. The gold standard left little room to adjust the money supply because new money could only be issued with a new supply of gold.
In the wake of the government deficits during the war, many countries were forced to abandon the rigid gold standard to print money freely. Following World War II and the Vietnam War, representative money was officially abandoned globally in 1971.
The end of representative money ushered in our current form of currency – fiat money. Fiat money does not possess intrinsic value nor is it backed by commodities. Rather, its value is determined by supply and demand, backed by the creditworthiness of the issuing government. It eases the severity of crises compared to under representative money because the government is able to print more currency.
Currency Supply and Demand
On a fundamental level, currency value is determined by supply and demand, both domestic and foreign. Increased demand appreciates the currency value, while increased supply decreases the currency value. Many factors may affect currency value, such as:
1. Interest Rates
Currencies of countries offering higher interest rates tend to increase in value, all else being equal. This is because fixed-income investors flock to higher interest rates, which increases the currency’s demand and value.
High inflation erodes the purchasing power of the currency holder and increases the cost of local goods. Countries that experience higher inflation may experience a decrease in currency demand, and therefore a depreciation in currency value.
3. Capital Flow
Capital flow represents a large portion of the demand for currency. Large amounts of capital inflow going into a country appreciate the currency, while capital outflow depreciates the currency.
4. Money Supply
Money supply refers to the money within a country at a given point in time. The higher the money supply, the lower the currency value and vice versa.
Measuring Currency Value – Exchange Rates
The most common way to measure currency value is by measuring its convertibility to other currencies – also known as the exchange rate. Since the end of the gold standard in 1971, the majority of the world’s currency has adopted one of two exchange rate systems:
1. Fixed Exchange Rate
A fixed exchange rate is when one country pegs its currency to an anchor currency so that both currencies move identically. Countries that opt for a fixed exchange rate are usually developing countries seeking currency stability.
The most common anchor currency is the US dollar since it is relatively stable and considered a safe haven in crises. The downside is that countries with a fixed exchange rate give up their policy independence and suffer from lower free trade and liquidity.
2. Floating Exchange Rate
A floating exchange rate involves letting the foreign exchange market determine currency value with respect to the supply and demand of other currencies. Countries under a floating rate system may experience higher exchange rate volatility but also benefit from exercising more autonomy over their economic policies and trade activities and enjoy higher liquidity. The government usually still intervenes occasionally to keep the exchange rate within a reasonable fluctuation band.
Exchange rates are an incredibly complicated mechanism that involves pricing in current events and equating hundreds of different currencies to their fair value so that no arbitrage is possible.
Arbitrage occurs when a pricing error spreads between different currencies that allows investors to take advantage and gain a riskless profit. Yet, such a mechanism becomes automatic because the aggregate actions of the foreign exchange market equate supply and demand of currencies worldwide.
CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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