We all know that currencies fluctuate in value. A European vacationer in the United States will be able to buy more for the same amount if dollar gains value against Euro. If dollar loses values against Euro, the opposite is also true. So, why does the value of a currency fluctuate? To answer this question, first we have to look at what a currency actually represents. A country’s currency reflects the health of its economy and investor confidence in its economic future. A strong and stable currency often represents a strong economy with a positive economic outlook.
How supply and demand impacts currency value
Currency prices, like all commodities, are determined by supply and demand. Currencies tend to gain value whenever its demand is greater than the available supply. It will become less valuable when its demand is less than the available supply. Reduced demand does not mean that people no longer want the currency; it simply means they prefer holding their wealth in some other form such can be gold, hard assets, or another currency.
Demand for a currency is due to both transaction demand and speculative demand for the currency. In simple terms, transaction demand refers to the use of the currency for economic activity. Every year tourists flock to Turkey for holidays. They spend money on sightseeing tours, hotels, food, and activities. These are all transaction and the tourists need to exchange their currencies to Turkish lira to pay for them. This increases transaction demand. Transaction demand is directly related to a country’s GDP and unemployment levels. These factors are influenced by political stability, natural disasters, interest rates, and monetary policy. GDP is a measure of the economic activity of a nation.
Speculative demand is not dictated by real transactions such as trade or finance. It is based on the speculation of the future value of a currency. For example, if oil is discovered in Jamaica, speculators would consider buying Jamaican dollar in large sums since they expect the country to grow rich in the future from the sale of oil. Thus the Jamaican dollar would gain value. However, it must be noted, that no real business activity is responsible for this increase. The oil is not yet being sold on the market. In general, the higher the interest rates, the greater the demand for a currency.
The exchange rate of a free-floating currency is allowed to vary against the rate of other currencies by the market forces of supply and demand. The value of a pegged currency is maintained by the government of the country at a fixed rate relative to some other currency. Although the value of most free-floating currencies fluctuate in response to market forces, governments tend to intervene from time to time and try to regulate the currency value through by increasing or decreasing the currency supply.
How health of a nation’s economy impacts currency value
Economic growth, interest rates, natural disasters and political stability affect the health of an economy. Investors want to invest in solid economies which are achieving steady growth. The best indicator for economic growth is the GDP. Higher GDP means higher growth rate of an economy.
Money tends to follow interest rates. If interest rates increase, money will flow into the country as investors seek to capitalize higher returns. Suppose you are an investor. Suppose Australia and Canada are offering 3% on their bonds, investors would consider both to be investments of similar reward as the economic strength of both countries is comparable. However, if Canada increases it interest rate to 5%, money will flock to Canadian bonds as investors would now perceive Canadian bonds to be better investments. Governments increase the money supply to stimulate economies. Government lower interest rates to encourage more people and businesses to borrow money, which in turn leads to an increase in demand for goods and services that money can buy.
Political turmoil, war, high unemployment and international conflict all scare investors. Who would want to invest in a country whose infrastructure could be destroyed in an expected war. Would you invest money in a hotel operating in war-torn Syria or Afghanistan?
Natural disasters cause financial damage and disrupt economic activities. Reduced economic activities result in the reduction of GDP.
Both overvalued and undervalued currencies can help or hurt a nation’s economy. Undervalued currency means that your products would be cheaper on the market, giving you a competitive advantage. An overvalued currency makes it more economical for a company to buy assets and invest in other countries where it would benefit from these investments in the future.
Summary
Many factor affect the value of a currency. All factors are tied to the stability of the country and the health and potential of the economy to grow. Since the demise of the gold standard, governments can artificially increase or decrease the supply of currency and also take measure to impact the demand for their currency.
