How is Currency Valued & Exchange rate decided?

Whether in your daily use or between countries, all the transactions today use either paper bills, credit cards, or cheques. It was not the case in history when the currency was equivalent to either coins, gold, or a commodity. While the forms of money have changed over the years, money has always been the lifeblood of any economy, every household, or individual.

But what gives money its value, deciding the units we get for trading it and how is currency valued in foreign markets? Keep reading to take a closer look and find out.

History of Currency and its Value

Currency didn’t exist until several hundreds of years ago and the barter system prevailed, where if you have a bag of rice and you need shoes then you could barter with the person having shoes. But it was a faulty system. What if the timing didn’t work when you needed shoes, the other person didn’t want rice, or who could even justify it as fair trade?

To replace the barter system, we had currency, firstly as “commodity money,” deriving intrinsic value from the precious metals they were made of. Silver, copper, cocoa beans, and seashells have been used as commodities for trade.

However, the impracticality of commodity money involving large risks of price fluctuations of the commodity prices created the shift towards “representative money”– money backed by its ability to be traded for a physical commodity. The most notable use of drifting from the currency of intrinsic value was under the gold standard, where each country’s currency is tied to a fixed amount of gold. However, during World War I, this gold standard only created major bottlenecks since money could be supplied only with a new supply of gold. Many countries ended up abandoning the rigid gold standard in the wake of their government deficits. Representative money was officially halted globally following World War II and the Vietnam War in 1971.

The end of representative money ushered in the current form of currency – fiat money, which neither possesses intrinsic value nor is backed by commodities. Rather the value of Fiat money is determined by supply and demand, backed by the creditworthiness of the issuing government. It eases the rigidity of representative money because the government is able to print more currency.

This money has been in the economy for years. You have been hearing from your grandparents and parents about how fuel or food was cheaper in their days than what it costs today. Who is deciding this increase or decrease, let’s move to deep diving into ‘how is currency valued?’

How Money Gets its Value?

There are several factors that affect the economy, those factors have a role to play in the valuation of a currency. These factors are the country’s imports and exports, inflation rate, level of employment, interest rates, growth rate, trade deficit, the performance of equity markets, foreign exchange reserves, macroeconomic policies, capital inflows- from foreign investment and banking, commodity prices, and geopolitical conditions.

While these factors fluctuate the currency and play a role in its valuation/devaluation, there are mainly two factors that determine the value of money

1. Existence of Money

On a fundamental level, it is the law of Supply and Demand. You spend more when you have more, right? If you spend more on imported goods then demand for foreign currencies will increase since your country will be purchasing those goods again, hence weakening the demand for local currency unless our exports increase too.

So you decide the value of money by how much people are willing to exchange it for (demand) and how much of it is available to be traded (supply).

2. Perception of the Value of Money

The second most important underlying cause of the value of money is based on our perception of its worth. Government announcements, news about a country, and its overall economic growth can alter the specific amount of value of money since that leads people to build a perception of the future of what the value could be.

Because of these two reasons for people’s perception of value, and the economic principle of supply and demand, money finds its value. And if it stays devalued over a long time then inflation occurs, vs when it stays strong then deflation. Continuous change of its value keeps the bar at the center.

How is the Value of Currency Measured?

Measuring a currency is possible by measuring its convertibility to other currencies – also known as the exchange rate. One of the following exchange rate systems exists for the majority of the world’s currencies, since the discontinuance of the gold standard in 1971:

1. Fixed Exchange Rate

When a country decides to peg its currency to an anchor currency for relative stability. Most of the developing countries anchor to the US dollar, finding this system effective since now both currencies move identically. But then these countries do not have control over their economic policy and trade activities, suffering from lower free trade and liquidity. Given that the government intervenes actively, there is a massive probability of devaluation of the currency.

2. Floating Exchange Rate

When a country lets the foreign exchange market determine currency value with respect to the supply and demand of other currencies. Such countries benefit from exercising more autonomy over their policy and may experience higher exchange rate volatility and higher liquidity. However, the government usually still intervenes occasionally to keep the exchange rate within a reasonable fluctuation band.

Given the drawbacks of both, most countries now adopt a mixed system of exchange rates where central banks intervene in the market to buy or sell the different currencies to control the movement of their own currencies.

Money being the medium of exchange in every economy encourages economic and trade activities, in turn evaluating itself. The value of currency ensures your purchasing power and is the measure of storage of your wealth, addressing long-term needs as well. 

Conclusion

In today’s digital economy that is heading towards decentralization, perception of the value of money plays a major role in how the value of a currency is determined, even before its true supply and demand in markets. From currency as a commodity to currency transcending the possibility of tangibility with the development of cryptocurrencies such as Bitcoin, currency may change its forms but will always be valuable.