Why Currencies Differ in Value?

Ever wondered why the U.S. dollar, the Euro, or the Vietnamese dong all have different values? Why isn’t one dollar equal to one Euro or one dong? The answer lies in the wonderful world of currencies, exchange rates and the things that depend on them. In this article, we’ll break down the key reasons why currencies have different values and why these values change over time.

A Brief History of Currency

The Gold Standard

In the past, money was tied to gold. The 'Gold Standard’ was the system by which a country's currency was backed by an amount of fixed gold. By doing this it prevented government from printing unlimited money and maintained exchange rates.

For example, Suppose the US wanted to issue more dollars, then the US had to have more gold on reserves. Yet, when world trade and economy stimulated, there was not enough gold for backing currency, especially in case of wars and economical crises.

Fiat Money

In the 1970s most countries abandoned the gold standard and embraced fiat money. Fiat money has absolutely no intrinsic value. It gets its worth from government backing and public trust. Fiat money is not 'backed' by gold, but by supply, demand, and people's trust in it; and therefore its value is quite different to gold-backed currency.

Why Do Currencies Have Different Values?

There is a mixture of economic factors that determine currency values. Here are the main reasons:

1. Supply and Demand

The more people who want a currency, the more it’s worth. As fewer people want it, the value of it goes down.

Example: the U.S. dollar is popular around the globe simply because people trust and use it to do international trade. However, economies such as Venezuela’s which are not very strong, lose currency value due to some reasons such as rate of inflation and low purchasing power.

2. Inflation

If the prices of goods and services go up, it’s called inflation and it means that a currency’s purchasing power decreases.

Example: Zimbabwe had a better currency with the international market in 1980s than the United States of America had. Still, as a result of economic mismanagement and hyperinflation, it just fell lower and lower in value. In the 2000s one US dollar became equal to 600,000 Zim dollar, it became valueless, and the country has to turn to foreign currencies such as the US dollars.

When there’s a high inflation currency becomes unattractive to the investors and traders causing their value to fall.

3. Interest Rates

Interest rates are the cost of borrowing money, set by a country’s central bank. Foreign investments tend to become attracted to higher interest rates because they receive better returns.

Example: Suppose that the U.S. pays higher interest rates than Europe then investors may invest in dollars at a higher rate making an exchange of Euros for dollars. therefore, this increases the value of dollar.

However, high interest rates have the –effect of limiting economic growth because borrowing costs increases for firms and individuals. Interest rates are fine tuned by central banks in a bid to keep an economy strong and maintain a strong currency.

4. Political & Economic Stability

Stable economies, stable governments tends to have stronger currency. Stability assures investors and it also eases foreign businesses to invest.

Example: After China started liberalizing in the 1970s, a host of firms rushed to establish production and affiliated facilities. These businesses needed Chinese yuan to be able to purchase necessities, which increased the demand for currency and hence improving its value.

On the other hand, nations with social uprising, strikes or change in policies experience their currency lose value because investors consider them to be unsafe.

5. Trade Balance

The currency of a country greatly depends on its trade activities.

• Exports: When countries sell goods to other nations, buyers need the seller’s currency. For example, Japan has a very dominant export market, this makes the yen in big demand.
• Imports: If a country imports more than it exports, it needs foreign currency to pay for goods; in consequence, its currency could be weakened.

Global prominence of the U.S. dollar was secured in the "Petrodollar" system which keeps trading of oil in dollars. That keeps the dollar in strong demand throughout the world.

6. Pegged Currencies

In some countries they peg their currency to a stronger one so that the currency stay stable.

Examples:

• Brunei’s currency is pegged to the Singapore dollar giving both the same value.
• Belize's currency is tied to the US dollar, so its $1 Belize will always be worth US $0.50.

On the other hand, although pegging gives stability, it creates the condition that set by the pegged currency is dependent on the stronger currency. The general rule in this connection is that if the anchor currency declines in value, the same applies to the pegged to it.

Why Not Have a Single Global Currency?

At first glance having a single currency for the entire world sounds convenient. However, it’s not practical.

Take the Eurozone as an example. While the Euro simplifies trade across Europe, it requires countries to give up control over their monetary policies. The consequences of the 2009 Greek financial crisis showed how economies could be connected and vulnerable to the same danger as the crisis spread through to other Eurozone countries.

If only one currency was used in the world, then the economic mismanagement in one country could bring down the economy.

Should Every Country Aim for a Strong Currency?

Not necessarily. A strong currency isn’t always ideal.

• Strong Currencies: If a country imports a lot, say Singapore, then a strong currency is a good thing as it makes the country’s imports cheaper.
• Weak Currencies: Countries that export a lot like China are usually in favour of weaker currencies, that make their products cheaper on foreign markets to increase exports.

FAQs About Currency Values

• Why do exchange rates change? The rates of exchange change due to many conditions for instance inflation rates, the interest rates, political conditions, and general economy performance.
• What’s the difference between fixed and floating currencies? Fixed currencies are that which is pegged to another currency while floating currencies change according to market forces.
• How does inflation affect currency? High inflation takes a toll on the value of a currency due to the depreciation of it’s purchasing power and thus makes the currency less attractive on the global market.
• Why do some countries use foreign currencies? Many times, unstable countries with unstable economies use foreign currencies to stabilize trade and finances.
• What is currency devaluation? Currency devaluation is a situation, where a country makes its currency cheaper in order to make exports cheap for the other countries.