A currency refers to a monetary unit issued by a state and accepted in international transactions, it is therefore an essential trade tool, allowing the purchase or sale of goods and services.
The following report is a brief and very basic demonstration of how a currency gets its value and the reasons behind the ups and downs of each exchange rate in forex charts.
Breaking down a currency
According to Aristotle, any currency has three main functions:
- A means of exchange: Without money, we would be forced to directly trade goods and services for other goods or services. Money, which is accepted by all, simplifies exchanges.
- A unit of account: Currency allows us to compare the value of different goods and services. This is the standard by which their prices are expressed. Currency also makes it possible to compare changes in costs, revenues and profits. It is therefore the foundation of accounting, a system that is used to plan and make economic decisions.
- A store of value: The currency is used to raise savings. It is the “liquid” reserve, easily and quickly transformable into any good or service.
These three functions can be fulfilled through all notes, deposit accounts and all investments that can be converted into cash (savings books, term accounts, etc).
Law of supply and demand
The major factors that shapes the value of any given currency are basically two things: offer and demand, which evolves according to the economic activity.
Commercial banks, constantly creates money, by granting credits, which makes up over 97% of all supply, just 3% is still in form of cash that you can touch.
Central banks in particular, through managing interest rates, play on the demand of these reserves to regulate the creation of money: they increase their level when they want to reduce the money supply in circulation or, on the contrary, reduce it to inject liquidity into the economy.
Inflation and deflation
If money supply becomes too abundant in relation to goods and services produced, inflation develops and erodes the value of money, and if, on the contrary, money becomes too scarce in relation to goods and services produced, deflation increases its value.
Inflation and deflation are diseases of the currency, which harm economic life. Thus, inflation surreptitiously changes the real value of contracts and savings, causing a redistribution of income and wealth. This redistribution makes losers and winners:
- Those who have saved in the form of money or fixed-income securities (such as bonds) are losers as the purchasing power of their capital crumbles.
- Those who borrow at a fixed rate are winners if their financial resources adjust to rising prices, since the debt burden is decreasing relative to these.
Rising prices erode the purchasing power of employees. They then demand salary increases, the rise in wages in turn causes prices to rise.
Unlike income redistribution through taxation and public spending, redistribution through inflation is not democratically decided. It is blind and very likely to be unfair. Above all, it strikes those who have had confidence in the stability of the value of money.
Inflation hurts not only equity but also economic efficiency. Indeed, it causes uncertainty and a loss of confidence that weigh on investment: Companies have difficulty predicting the evolution of their prices and their costs, to plan their investments and make the right decisions.
The situation of borrowers, especially companies looking to finance their investments, eventually deteriorates.
Deflation is also harmful for economic activity, it causes a blind redistribution of income and wealth, increased uncertainty and a loss of confidence.
A deflationary spiral leads to a drastic contraction in activity, lower prices put companies in difficult situations and force them to lay off staff, in the face of rising unemployment, households are reducing their purchases of consumer goods, and this decline in demand is causing a further contraction in activity, which in turn is affecting prices.
It is therefore price stability that offers the best conditions for sustainable and job-creating growth, while protecting the purchasing power of those who trust the currency.
Govern the value of a currency
The central bank, custodian of the currency, has a particular responsibility in maintaining price stability. However, it does not control prices directly: In our economies characterized by a developed financial system, the money supply evolves according to the decisions of many actors who, for example, want to place their savings
in deposits in the short term, included in the monetary supply, or in long-term bonds.
What the central bank controls, the main instrument of its monetary policy, is the interest rate at which it grants very short-term loans to commercial banks. By changing its interest rate, the central bank also influences the rates charged by commercial banks.
In the face of a threat of inflation, the central bank will raise its interest rate. Higher rates will result in the expansion of credit and supply and demand for services. On the contrary, if there is a risk of deflation, the central bank will lower its interest rate, so as to avoid lower prices.
Foreign exchange reserves
Foreign exchange reserves also affect the value of any given currency, that is the mass beared by foreign governments, the amount held affects its supply in market, which fluctuate its value relative to other currencies.
If, for example, foreigners agree to dump their dollar savings at once, it would drastically crush.
Exporters of the country deposit foreign currency in their local banks, which transfer them to the central bank, exporters are paid in foreign currencies, then they trade them for local money, which will be used later to pay their employees and local contractors.