Central to the idea of forex trading is the notion of currencies having different values as they relate to each other. Some currencies tend to be more expensive and others tend to be cheaper, and they move in different price cycles depending on a number of external factors and market pressures. But why are currencies valued differently in the first place? Why isn’t it the case that currencies are internationally pegged, which would presumably make trading on a level playing field more possible? It all starts with understanding value.
A single US dollar is the base unit of currency in the US. A dollar will buy you a small bottle of your favourite branded soft drink. A single British pound is the base unit of currency in the UK, and it will also roughly grab you the same product. Whether you’re spending $1 in the US or £1 in the UK, you can roughly expect the same ‘bang for your buck’. But the exchange rate of GBP (UK) and USD (USA) (that’s the amount of USD you get for every GBP) varies between around 1.2 and 1.6 dollars to the pound. As a result, this tends to mean that £1 is roughly equal to $1.40, with natural bands of fluctuation. Domestically, each currency is respectively worth effectively the same value. But introduce the Atlantic, and all of a sudden the value has completely changed. All of a sudden, the American soft drink owner would rather hold £1 in his hand than $1.
The Currency Riddle
So what’s this all about then? Actually, this issue delves into the murkiest waters of economic theory, so its worth bearing with the response.
Currencies are, like anything, subject to supply and demand. If demand outstrips supply, currencies increase in value. If supply outstrips demand, the reverse occurs. Currencies tend to be controlled at a national level (see the Euro for a prominent example, which many commentators suggest could result in its downfall), and as a result are made and kept scarce to ensure they retain value.
Currency values are driven to a large extent by interest rates and regulation of the money supply. Printing more banknotes devalues all bank notes in a particular currency, which makes it cheaper for goods to be exported. All things being equal, the currency of the buyer (i.e. the party not printing more notes) will retain its value, while the currency that is being flooded with more supply will lose its value. In the same way, if interest rates are raised, investors looking to deposit their cash will do so in higher interest bearing economies, thus fuelling demand and pushing up currency prices.
Why This Is Important
Having currency that can fluctuate in value is crucial for controlling imports and exports, and it is suggested that without the ability to vary currency values, countries would collapse. The example of Greece following the eurozone debt crisis is one for which many analysts criticise the euro. Facing massive national debts and escalating borrowing costs, Greece as a eurozone country was unable to do anything to stimulate its economy from the outside.
Were the UK to find itself in similar difficulties, or any other non-eurozone country for that matter, the first step would be a devaluation of currency which would prompt investment and growth from outside capital (as we saw it during Brexit). This ability to vary currency valuations allows governments to take decisive action to boost and cool their economies respectively as economic conditions demand, and the finesse and clarity with which these mechanisms interrelate is breathtaking to anyone faintly interested in macroeconomics.
So that’s a round up of why currencies have different values, and for the most part sovereign states are keen to keep full authority over their own currency valuations, in order to take advantage of the full scope of manual economic tweaking measures currency valuations present.
In addition to government driven prompts, there are also a number of market driven prompts which give reason as to why currencies might fluctuate in value.