How is Currency Valued (2024)

Factors that influence the value of currencies

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Currency value is determined like any other good or service in a market economy – through supply and demand. Factors affecting supply and demand are regulated by the government through monetary and fiscal policy.

How is Currency Valued (1)

Summary

  • Currency value is determined by aggregate supply and demand.
  • Supply and demand are influenced by a number of factors, including interest rates, inflation, capital flow, and money supply.
  • The most common method to value currency is through exchange rates.The two main exchange rate systems are fixed rate and floating rate systems.

History of Currency Value

Currency came around several hundreds of years ago as a means to replace the barter system. Early currencies were “commodity money,” meaning they derived intrinsic value from the precious metals they were made of.

However, the impracticality of commodity money created the shift towards “representative money” – money that lacks intrinsic value but is backed by its ability to be traded for a physical commodity. The most notable use of representative money is under the gold standard, where each country’s currency is tied to a fixed amount of gold.

The drawbacks of the gold standard became clear during World War I. The gold standard left little room to adjust the money supply because new money could only be issued with a new supply of gold.

In the wake of the government deficits during the war, many countries were forced to abandon the rigid gold standard to print money freely. Following World War II and the Vietnam War, representative money was officially abandoned globally in 1971.

The end of representative money ushered in our current form of currency – fiat money. Fiat money does not possess intrinsic value nor is it backed by commodities. Rather, its value is determined by supply and demand, backed by the creditworthiness of the issuing government. It eases the severity of crises compared to under representative money because the government is able to print more currency.

Currency Supply and Demand

On a fundamental level, currency value is determined by supply and demand, both domestic and foreign. Increased demand appreciates the currency value, while increased supply decreases the currency value. Many factors may affect currency value, such as:

1. Interest Rates

Currencies of countries offering higher interest rates tend to increase in value, all else being equal. This is because fixed-income investors flock to higher interest rates, which increases the currency’s demand and value.

2. Inflation

High inflation erodes the purchasing power of the currency holder and increases the cost of local goods. Countries that experience higher inflation may experience a decrease in currency demand, and therefore a depreciation in currency value.

3. Capital Flow

Capital flow represents a large portion of the demand for currency. Large amounts of capital inflow going into a country appreciate the currency, while capital outflow depreciates the currency.

4. Money Supply

Money supply refers to the money within a country at a given point in time. The higher the money supply, the lower the currency value and vice versa.

Measuring Currency Value – Exchange Rates

The most common way to measure currency value is by measuring its convertibility to other currencies – also known as the exchange rate. Since the end of the gold standard in 1971, the majority of the world’s currency has adopted one of two exchange rate systems:

1. Fixed Exchange Rate

A fixed exchange rate is when one country pegs its currency to an anchor currency so that both currencies move identically. Countries that opt for a fixed exchange rate are usually developing countries seeking currency stability.

The most common anchor currency is the US dollar since it is relatively stable and considered a safe haven in crises. The downside is that countries with a fixed exchange rate give up their policy independence and suffer from lower free trade and liquidity.

2. Floating Exchange Rate

A floating exchange rate involves letting the foreign exchange market determine currency value with respect to the supply and demand of other currencies. Countries under a floating rate system may experience higher exchange rate volatility but also benefit from exercising more autonomy over their economic policies and trade activities and enjoy higher liquidity. The government usually still intervenes occasionally to keep the exchange rate within a reasonable fluctuation band.

How is Currency Valued (2)

Exchange rates are an incredibly complicated mechanism that involves pricing in current events and equating hundreds of different currencies to their fair value so that no arbitrage is possible.

Arbitrage occurs when a pricing error spreads between different currencies that allows investors to take advantage and gain a riskless profit. Yet, such a mechanism becomes automatic because the aggregate actions of the foreign exchange market equate supply and demand of currencies worldwide.

More Resources

CFI offers the certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Creditworthiness
  • Fixed vs. Pegged Exchange Rates
  • Intrinsic Value
  • Money Minting
  • See all economics resources
How is Currency Valued (2024)

FAQs

How is our currency valued? ›

Currency value is determined by aggregate supply and demand.

How to tell if a currency is overvalued or undervalued? ›

If the PPP exchange rate of a currency implied by the local price of a given good or basket of goods is lower than the currency market exchange rate, then the exchange rate is overvaluing the local currency relative to its real purchasing power, and if the rate implied by the local price is higher than the market ...

Why is currency valuation important? ›

A higher currency value means imported goods are more affordable. That's highly relevant in most countries, where products like electronics and cars are mostly imported. For investors, a change in currency values can help or hurt the real return they're getting on their investments.

How do you know if a currency is worth more? ›

The relative strength and weakness of a given currency versus a rival is influenced by a number of factors, but the most common are the interest rates of each country, the trade balance of each country, and the perceived stability of the currency and the governments.

How do we know what our money is actually worth? ›

Federal Reserve Notes are bills issued between 1914 and the present in denominations ranging from $1 to $10,000. The worth of a modern bill depends on its serial number and how unusual it is. Collectors look for several different types of fancy serial numbers that stand out from the crowd.

What is the US dollar backed by? ›

Prior to 1971, the US dollar was backed by gold. Today, the dollar is backed by 2 things: the government's ability to generate revenues (via debt or taxes), and its authority to compel economic participants to transact in dollars.

Which country has an undervalued currency? ›

The currencies of South Korea, China, and the Eurozone are now all undervalued by more than 20%, giving those nations substantial advantages in global markets and especially in exporting to the U.S. Since 2011, the U.S. dollar has risen by 48%, as measured by the Federal Reserve's broad dollar index.

Is the U.S. dollar overvalued or undervalued? ›

The dollar is overvalued by a large double-digit margin against most major currencies, due to the growing conviction that U.S. interest rates will be higher for longer, while other central banks like the ECB are getting close to cutting rates,” said CPA chief economist Jeff Ferry.

Which currencies are overvalued? ›

Currency Misalignment Monitor, July 2023
Currency Misalignment Monitor, July 1, 2023
Currency% Over/Under valuation (1)
ChinaYuan25.0%
JapanYen45.7%
KoreaWon29.6%
10 more rows
Jul 3, 2023

Who decides the value of your currency? ›

Most of the time, market forces like consumer demand determine the value of a currency. But there are exceptions. Some countries have been accused of manipulating their currencies, usually to make them weaker so their exports seem cheaper and their manufacturers benefit.

What is the weakest currency in the world? ›

Iranian Rial (IRR):

Iran's official currency, the Iranian Rial (IRR), is currently the world's least valuable currency, with 1 Indian Rupee (INR) equaling 503.97 IRR. This depreciation is primarily influenced by political unrest, the lasting effects of the Iran-Iraq war, and the country's nuclear programme.

Which currency is worth the most in the world? ›

The highest-valued currency in the world is the Kuwaiti Dinar (KWD). Since it was first introduced in 1960, the Kuwaiti dinar has consistently ranked as the world's most valuable currency.

How could U.S. currency lose value? ›

Printing too many legal bills: If the government prints an excessive amount of money, it can lead to inflation. Inflation reduces the purchasing power of each dollar, as more money is available but the value of goods and services does not increase proportionally.

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