Understanding what determines the value of a currency is an essential first step in making predictions on the appreciation or depreciation of a currency. From there, you can take the general factors and research them in the specific context of the currency you are interested in.
Thus, this article will explain which elements play a role in establishing the value of a country’s currency, how you can weigh them against each other, and how exchange rates and inflation factor in. But, before we delve into what determines the value of a currency, we should give a brief historical overview so you can understand how we got to the modern concept of currency.
Let’s dive in!
Money concepts have not been consistent throughout history. The ancestor of modern money is commodity money, which is a currency made from precious metal. So, bronze, silver, or gold coins in general. In this case, it was relatively easy to determine the value of money as its value was the same as the precious metal it was made of.
Commodity money was followed by representative money, which is the direct precursor to modern currency. Representative money is money that has no intrinsic value of its own but is backed by a physical commodity. The gold standard is the most famous example of the use of commodity money – where a country’s currency is pegged to a fixed amount of gold.
From the 18th century onward, most countries around the world started using representative money (usually based on the silver or gold standard), until after World War I when it started getting phased out. The U.S. dollar was based on the gold standard until 1971 or 1976, depending on how you interpret it.
In 1971, then-president Richard Nixon ended the international convertibility of the dollar to gold, while in 1976, the Government changed the definition of the dollar and removed any references to gold. Thus, 1976 is the latest when the U.S. dollar can be considered to have truly become what it is today – fiat money.
Fiat money has no intrinsic value, like commodity money, nor is it backed by a physical commodity, like representative money. In this case, the value of money is, broadly speaking, based on money supply and demand and backed by the government that issues it. And that is the main topic of this article.
If you’re wondering how currency value is determined and which factors play a role in establishing the value of a country’s currency, it all boils down to its supply and demand.
In its most basic form, the more demand there is for a currency, the higher its value. Conversely, a larger supply of a currency decreases its value. Two primary factors influence how much of a currency is in circulation: how much the government prints and how much is held in forex (foreign exchange market) reserves.
Smart economic policies are the cornerstone for the strength of a currency. When a government prints too much money, its value decreases, leading to a devaluation of the currency, both on the domestic market and in the international market.
The second factor in valuing currencies is forex reserves, but this primarily refers to the money supply of the dollar and the euro, to a lesser extent. Forex reserves are cash or other assets controlled by a country’s monetary authority that is used to balance payments and influence the country's exchange rate.
As most countries’ reserve currency is the U.S. dollar, they can influence the supply. Thus, the more other countries have in reserve, the less supply of the dollar or euro, leading to higher demand and, consequently, a higher value. Conversely, if many countries decided to sell their reserves, the dollar supply would significantly increase, leading to its depreciation.
The demand for a currency is determined by various market factors, such as the supply, but also trust in the creditworthiness of the country issuing the currency, the political stability of the country, the economic strength, an expected rise in value, etc.
Wondering which factor plays a role in establishing the value of a country’s currency? Exchange rates are influenced by a complex interplay of economic, political, and social factors. Understanding these factors can help individuals and businesses make informed decisions about investing and conducting transactions in different currencies.
There are several indicators that can help predict whether a county’s currency will increase in value. None of these are infallible, and changes in economic policy can cause dramatic shifts in the value of a currency, but appreciation or depreciation is usually a lengthy process, so considering these factors in unison can lead to good predictions.
So, what causes exchange rates to change?
Inflation is the rate at which prices increase and the purchase price (purchasing power) of a currency decreases. Inflation is normal in a country that uses fiat money and is usually controlled by the central monetary authority, but the rate of inflation can indicate whether a currency is going strong or not.
A high rate of inflation can lessen trust in the stability of a currency and consequently lower the demand, leading to a lower value. In worst-case scenarios, governments print exorbitant amounts of money to keep up with inflation, which leads to even more depreciation and, finally, hyperinflation, making the value of money in a country effectively worthless.
On the other hand, low inflation rates can make a country's currency more attractive to investors and lead to an appreciation in its value.
One of the primary drivers of a country’s exchange rate changes is interest rates. High-interest rates usually indicate that a currency will increase in value. They attract foreign investors, leading to an increased demand for the currency and, thus, driving up its value. Conversely, lower interest rates can deter foreign market investment and cause a country's currency to depreciate.
However, interest rates need to be viewed in relation to inflation, as higher interest rates are often accompanied by an increase in inflation, which can nullify the potential appreciation due to the inflation rates.
With more capital investment in a country, the better it is for the corresponding currency. Political and economic stability and good monetary policies can lead to foreign investors flocking to a country, increasing the demand for the local currency. Conversely, capital outflow lessens the demand and depreciates the currency.
Geopolitical tensions, such as trade disputes and political instability, can also impact currency exchange rates, have negative consequences, and have a hand in valuing currencies. When countries engage in trade wars, they may impose tariffs or other trade barriers, which can lead to a decrease in demand for each other's currencies. Political instability, such as elections or social unrest, can also lead to uncertainty and cause investors to pull out of a country's markets, leading to a depreciation in its currency.
Most countries have a certain level of debt, and even higher levels of debt are manageable. The level of the national debt is usually measured in relation to the GDP (although this is a very complex subject, and there are many competing theories). Regardless of how its measured, high levels of debt often lead to high inflation, ultimately devaluing the country’s currency.
The currency exchange rate is the simplest way to measure the value of a currency. How much a unit of currency can buy another currency is the simplest method of valuing currencies, as forex traders take money supply and demand into account and make predictions based on their expectations.
However, there are two types of exchange rate systems.
Some countries peg their currency to another, stronger currency. Thus, the movement of the former currency is determined by the movement of the latter. Many exotic currencies used in developing countries use the fixed exchange rate with the aim of gaining stability.
The U.S. dollar is a common anchor currency. Exotic currencies with a fixed exchange rate are usually more stable but also less liquid and tradable. Speculators often aren’t interested in fixed exchange rate currencies, are there is less of a chance for drastic increases in value.
The value of a currency with a floating exchange rate is determined by the supply and demand in the foreign market exchange (forex). These currencies are often more volatile compared to the previous group but are also more interesting for speculators for that exact reason.
More autonomy allows currencies backed by a good economy to appreciate significantly. Naturally, the flip side is that a declining economy and bad monetary policies can depreciate the currency quickly. Thus, investing in currencies using a floating exchange rate is risker but potentially more profitable.
Now that you know which factors play a vital role in establishing the value of a country’s currency and the indicators of potential strengthening or weakening, you may choose to invest yourself in the foreign market and seize a fantastic market opportunity.
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Currency is valued based on a range of factors you can read more about above, including economic strength, political stability, inflation rates, interest rates, the level of trade (the trade balance), and market demand.
The value of one currency against another is determined by the foreign exchange market, where supply and demand for each currency are constantly changing based on various economic and political factors.
In short, the value of a currency indicates its purchasing power and relative strength compared to other currencies. A strong currency can indicate a strong market economy, while a weak currency may suggest economic instability.
Kuwaiti Dinar (KWD) is currently the world's most valuable currency, followed by the Bahraini Dinar (BHD) and the Omani Rial (OMR) as the most valuable foreign money today.
Each country decides which currency to use as its legal tender, but the global standard is for countries to have their own national currency instead of a foreign currency.
A country can increase the value of its currency by implementing policies that promote economic growth, such as reducing inflation, increasing interest rates, and improving the level of trade, that is, the balance of trade with its trading partners. Together, these factors impact a country’s exchange rates and currency value.
Although currently not the most valuable currency in the world, the US dollar is a strong and dominant currency in the international market, as well as the domestic market, due to the size and strength of the US’ advanced economy, the stability of the political system, the widespread use of the dollar in international trade and finance, and the policies of major international organizations such as the IMF and World Bank.
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