If you’ve ever watched the TV show “Money,” you know that figuring out how much your dollar is really worth can be pretty complicated. That’s because when economists look at something called an exchange rate, they’re trying to figure out what determines the actual value of one currency compared to another (in other words, how many Swiss francs or South African rand are equal in purchasing power to $100 U.S.).
But before we get into those specifics, let’s talk about what makes up the value of money. And while it may seem like a complicated topic, it actually has several components more important than others. In fact, the most importants concepts are also the simpler ones to grasp.
“There are six major factors that determine the value of any given currency,” says Chris Lowman, chief economist at FTN Financial LLC. “They range from macroeconomic issues like interest rates to microeconomic ones such as inflation.”
What gives money value?
To put it simply, what gives money value is the promise that this or that amount of money can be, later, exchanged against goods or services. This promise is usually guaranteed by a state (fiat currencies) or people (bitcoin). Let’s take an example: France use euros since 2002, and was using the “franc” before that date. What happened is that, on that given date, France established that you’ll not be able anymore to exchange francs against goods and services. Instead, they have given the promise that the franc can be exchanged against euros, and then the euro was promised to be tradable against goods and services. And that’s all you need to create a currency out of thin air.
Now take a look at your bank account. All that money has value, because your country promised you that you can use that given amount to buy “things” to other people. If that promise goes away, other people (especially foreigners and other countries peoples) will probably not want to give you goods against your money and overnight it’ll become worthless.
Now that you know where does this value comes from, let’s see what can change the value any given money amount can represent.
How Does the Value of Money Work?
Here are the six key factors that influence the value of money:
Supply and demand
This refers to how many units of a specific type of currency exist in circulation. For instance, if people want to buy goods and services priced in U.S. dollars but only have cash available in euros, prices will adjust so that they can pay with the most widely accepted currency. This also means that when supply increases, the price per unit goes down.
In addition to this, demand plays a part in determining the value of a currency. If someone wants to purchase products priced in U.S. dollars, but their country only accepts Euros, then the demand would drive up the Euro against the dollar. Spread this across thousands of countries, thousands of currencies, millions of buyers, sellers, and transactions per day, and you’ll get a pretty accurate vision of our worldwide economic landscape.
Also when a country is printing money means that this money is created out of thin air, without any value backing it. Basically, the supply of money goes up, but the demand stay the same. Mechanically this drive the valuation of the money down, meaning the same amount of money equals fewer goods per unit. For example, during the covid pandemic, the US printed tons of money. Meaning, what you could be buying with 100$ before the pandemic now cost 120$ (for example) because everyone got free money out of nothing of value.
Capital flows and liquidity
Capital flow is basically the inflow of funds into different countries. When capital inflows increase, capital becomes more liquid. So if investors start pouring money into a certain nation’s bonds or stocks, confidence in that economy grows. The result is higher bond and stock prices, which translates into lower borrowing costs for companies and consumers alike. These savings provide a boost to the local currency, ultimately making it stronger. Again, the underlying effect is about supply and demand. If capital flow into a country and not into others, that means this country have mechanically more value than other countries.
Interest rates affect both supply and demand. As mentioned earlier, when the amount of money flowing into a particular area increases, the prices of things bought with that currency decrease. On top of that, banks and businesses need loans to stay afloat, so they’ll borrow money at a lower cost. Lower borrowing costs make lenders feel confident enough to lend even more money, creating even greater demand for a given currency.
Political risk refers to whether a government is able to keep its word. If there are concerns over the stability of a government, investors might not invest there due to fear that changes could cause big problems for the financial system. Or, if there is political unrest, it may lead to a devaluation of the local currency.
So if a company was doing business in China and had plans to expand to the United States, they’d likely consider the risks involved in moving manufacturing operations overseas. They’d also weigh the potential benefits of the investment in light of these risks.
Price levels tend to rise when economic growth occurs. However, high inflation can hurt the value of a currency by causing prices to jump around more frequently.
For example, if prices were rising quickly every time you went shopping, you wouldn’t be happy with your purchases. But if inflation happens gradually, your dollars would still lose value over time.
Although it seems counterintuitive, low inflation can also help bolster the value of a currency. While it’s true that rising inflation usually depreciates the value of a currency, it does serve a purpose. Namely, it reduces demand for commodities like oil and gold. That means more resources remain available for the development of domestic industries. Eventually, this helps stimulate the economy, leading to stronger currencies overall.
Government Policies and Actions
A change in government policy toward foreign investments can also negatively impact exchange rates. An investor who puts his money into a foreign market based on a stable government may find himself stuck once that government changes course.
As an example, if a new president suddenly decided to take away all access to foreign markets, he or she could potentially put downward pressure on the value of a chosen currency.
Finally, speculators play a role in the value of currencies, especially during times of uncertainty. They hope that unexpected events will drive the value of a given currency down. Then, after prices drop, they sell off their shares fast, driving down the currency’s value further. These moves are usually short term as this doesn’t change the underlying value of the country. It can, however, add significant noise making it difficult to assess the real underlying value.
Speculative forces can drastically alter the value of various currencies. During times of economic instability, investors may rush to exit the market by selling off their holdings in hopes of locking in a profit. However, this activity can also contribute to the devaluation of a currency if the speculation turns sour. The more the currency devaluates, the more speculators will try to get out as fast as they can, thus driving the currency even lower!
The Biggest Factors in Determining Exchange Rates
Now that we understand the basic principles behind the value of money, let’s look at the factors that influence exchange rates the most. Let’s breaks them down into four categories:
Diversification and Stability are Important for Financial Security
One way to protect yourself from volatility in the global marketplace is through diversification. By investing in multiple types of assets rather than just relying on one type of asset, you reduce the overall risk of losing money.
Stability is also crucial. You don’t want to fall victim to panic selling in response to negative news. One way to do this is to use stop-loss orders to limit losses should the value of a currency begin to decline rapidly.
This also goes for whole countries. Let’s imagine a country getting 90% of it’s value from tourism. When a pandemic like covid hit an put a stop into all tourism and travel related activities, suddenly this country lose all of his value against other, less impacted ones. On the other hand, let’s imagine a monopoly where a single country is supplying gas to tons of others. Loosing or increasing the gas production can make or break all value into that country, just because they aren’t diversified enough to ensure stability.
Fluctuations of supply and Demand
Supply and demand is one of the main drivers of exchange rates. A strong economy typically leads to increased demand for a given currency, encouraging other nations to strengthen their own currencies as well.
On the flip side, an unstable economy causes demand to fluctuate. For example, when the world experiences a recession, it tends to bring down the value of the affected country’s currency.
Demand doesn’t necessarily mean total population, either. Instead, it refers to how much of a currency is used in the economy. If everyone decides now is a good time to travel abroad, demand for tourism destinations’ currencies rises dramatically.
Capital Flows and Liquidity
Liquidity refers to the ease with which a person or institution can convert one type of asset into another form. For example, if someone needs to transfer money between two different currencies, they’ll probably choose to move it via check instead of holding onto large amounts of cash.
Cash isn’t always the best option for converting currencies. With checks, transfers are faster and less prone to error. Plus, since they can be cashed immediately, they allow for bigger transactions. However, if there aren’t sufficient checks available, a bank account might be a better alternative. Banks offer easier ways to convert currencies without having to rely solely on the slow process of exchanging paper bills and coins.
Just like individual investors, corporations must worry about the effects of politics on their bottom line. Let’s say a multinational corporation headquartered in France wanted to open a branch office in a developing country where corruption and bribery are rampant. Even though the French government has strict anti-bribery laws, the company may decide that operating in these environments outweighs the risk.
Corporations often employ strategies known as “political capital management” to mitigate the effects of political risk. For example, they may set aside a portion of profits for contingency purposes. They also try to ensure that employees working in politically risky areas receive training in ethics and compliance.
Of course, governments also have a hand in influencing exchange rates. Some examples include monetary and fiscal policies enacted by central bankers. These decisions affect the supply of money, which affects the availability of credit and therefore demand for a currency.
Monetary policies also refer to the setting of short-term interest rates. Higher rates discourage saving, meaning less money gets invested in the economy. Lower rates encourage spending and investments.
Fiscal policies affect long-term interest rates. Governments enact these types of policies to achieve balanced budgets or fund programs. Since they require ongoing funding, they can significantly influence the value of a currency.