Each day in the news we hear information about changing currency rates. Whether your national currency is reaching a record high, suffering from a record low, or has been stable for some time, you might find yourself asking “what is this all about?” The value of our currencies affects everything from our purchasing decisions at the supermarket, what we order online, where we go to shop and, more broadly, the wealth of our nations.
This resource article will help you understand why currencies fluctuate in value and how those fluctuations can affect you. We’ll look at some of the mechanisms that affect the value of currencies in the exchange market, how that value is measured and what it all means to you.
Measuring the Value of a Dollar
The value of a currency is given relative to the value of other currencies that are typically more stable. Unless your currency is experiencing rapid inflation or deflation, the only indicator that things are changing could be what you see on the news.
Around the world, the American Dollar is the standard to which other currencies are compared when determining their fair market value. The Dollar is viewed as a global currency for several reasons related to its economic strength and stability.
Source: Banknote World
Currency Rates Fluctuate due to Changes in Inflation
One of the main reasons for changes in the relative values of currency is differential inflation rates between countries. Countries with low inflation increase their purchasing power over time relative to other nations. In the last half-century, Japan, Germany, Switzerland, Canada and the United States have managed to maintain low rates of inflation and strong global currencies. Countries like Argentina that have experienced high inflation in the last fifty years have also seen the relative buying power of their currencies diminish compared to the Euro, USD, and Canadian dollar, which have all remained relatively strong.
High inflation is often accompanied by high interest rates – if a bag of milk costs $100, but will cost $150 by next year, it’s important to charge high interest rates, otherwise lending becomes impossible and citizens can be put at risk without access to credit.
Currencies fluctuate when Interest Rates Change
As you might have guessed from the above, interest rates, inflation, and exchange rates are highly correlated. Central banks control interest rates, allowing lenders to get high rates of return and attracting foreign investors who want to lend money to locals. This effect causes the exchange rate to rise as foreign investors purchase local currency to take advantage of high interest rates. When inflation is high, however, the benefits of this practice can be nullified by the rising cost of goods and the diminishing relative value of currency.
Exchange Rates are Influenced by Public Debt
Many governments carry a lot of debt as a result of paying for public-sector services like road maintenance and health care, and although these activities are beneficial for the societies in which they are carried out, they are not as attractive for foreign investors. Large debts encourage inflation as governments struggle to accumulate cash. When inflation is high, the real value of the debt decreases along with the value of the currency itself, and it can be paid off in the future for cheaper dollars.
Some governments have even tried printing money to pay off massive national debts, but increasing the money supply leads to inflation and currency devaluation. If a country defaults on its national debt, it signifies economic instability and is a major red flag for foreign investors. Defaulting on your debt as a nation is the same as missing a mortgage payment at the bank – it won’t inspire confidence for folks that might want to invest with you.
Currency Valuations Fluctuate with Changes in Trade
Currency valuation is also tightly connected to trade deals that exist between countries. Countries that export a greater value of goods than they import often have solid currencies that reflect their domestic productivity. A country whose exports increase at a greater rate than its imports is showing improved terms of trade and creating a global demand for its currency so that people can buy its products. This increase in demand directly influences the relative value of currency. This is exactly what the US has done – it distributes products around the world in exchange for US dollars and its status as a true global currency keeps its value high relative to other currencies.
Taking Advantage of Exchange Rates
Foreign exchange currency trading is a risky business, but there are more concrete ways to leverage currency fluctuations for your benefit. If you live in a country where labour is cheap, develop a skill that allows you to work remotely and get paid in foreign currency – chances are your wages will be much higher than at home. If you live in a rich economy with a highly-valued currency, you may be shocked to find that the cost of living elsewhere is much cheaper compared to where you live.The paycheck that barely covers your rent in San Diego could allow you to live like a King in Argentina –it’s up to you to find out and make it work!
Conclusion
Ultimately, there are many factors working in tandem that affect the fluctuating values of currency both nationally and internationally. Countries with less political and economic stability and higher inflation can offer high interest rates, but it’s important to understand the whole picture before investing money in a foreign currency. Inflation, interest rates, public debt and international trade are all critical points of investigation for anyone wanting to understand the peculiar nuances of the International Money Market.
