eli5 How can Iraq decide their currency value when other currencies are based on Forex market? Additionally what stops them from making the currency super valuable?
In: 1
What you are referring to is “pegging” the currency. The value of the currency is defined according to some reference such as a different currency or measure of value.
Supply, demand, and the foreign exchange market don’t just vanish as you recognized. In order to maintain this pegged value the government of the currency must “defend the peg” by buying and selling its own currency on the open market, often maintaining foreign currency reserves.
For example if the Iraqi government wants to peg the dinar at 1450 to 1 USD then regardless of if the market at large thinks a dinar should be worth say 1200 to 1 USD, the Iraqi government will give you 1450 dinar for 1 USD and vice versa. They need to buy their own dinar and USD in order to do that though, at whatever the current forex rate is.
This should reveal the issue with pegging their currency as extremely valuable. If tomorrow they pegged the dinar as equal to the USD then when someone gives them dinar they would need to pony up USD equal to that amount. Chances are they will be the only entity willing to make that trade and getting the USD will involve massive losses.
There are three things a country might (or might not) like to do with their currency: of which they must choose at most two:
* “Fixed” or “Pegged” exchange rate. Iraq, as you noted, has done this. So did Malaysia, for a few years after the Asian Financial Crisis of 1997. Most countries do not bother with this, since it’s usually doesn’t have any obvious advantages.
* Free flow of money in and out of the country. This makes trade much easier, of course.
* Control over monetary policy – for example, countries often like to be the ones to decide how much of their currency is available.
The reason countries can choose at most two of these is this. Suppose they want to fix their exchange rate.
* If money can freely flow in and out of the country, then (as /u/Phage0070 noted), the country must buy (and destroy) or (create and) sell its own currency, in order to be a “market maker” that keeps the price within an “acceptable” range. Since their money supply is determined by market whim, they have lost control over their monetary policy.
* The alternative is to impose laws on currency traders within the country to ensure the desired exchange rate is maintained, and then to impose strict laws on the movement of currency, so that people can’t efficiently exchange the money overseas. This is what Malaysia did after the Asian Financial Crisis – they eliminated high-denomination banknotes, for example, and imposed strong limits on how much Malaysian cash a traveler could carry with them, as well as laws affecting banks directly.
* Most wealthy countries allow (relatively) free flows of money, and maintain control of their monetary policy – but that means their exchange rate is variable.
What you are referring to is “pegging” the currency. The value of the currency is defined according to some reference such as a different currency or measure of value.
Supply, demand, and the foreign exchange market don’t just vanish as you recognized. In order to maintain this pegged value the government of the currency must “defend the peg” by buying and selling its own currency on the open market, often maintaining foreign currency reserves.
For example if the Iraqi government wants to peg the dinar at 1450 to 1 USD then regardless of if the market at large thinks a dinar should be worth say 1200 to 1 USD, the Iraqi government will give you 1450 dinar for 1 USD and vice versa. They need to buy their own dinar and USD in order to do that though, at whatever the current forex rate is.
This should reveal the issue with pegging their currency as extremely valuable. If tomorrow they pegged the dinar as equal to the USD then when someone gives them dinar they would need to pony up USD equal to that amount. Chances are they will be the only entity willing to make that trade and getting the USD will involve massive losses.
There are three things a country might (or might not) like to do with their currency: of which they must choose at most two:
* “Fixed” or “Pegged” exchange rate. Iraq, as you noted, has done this. So did Malaysia, for a few years after the Asian Financial Crisis of 1997. Most countries do not bother with this, since it’s usually doesn’t have any obvious advantages.
* Free flow of money in and out of the country. This makes trade much easier, of course.
* Control over monetary policy – for example, countries often like to be the ones to decide how much of their currency is available.
The reason countries can choose at most two of these is this. Suppose they want to fix their exchange rate.
* If money can freely flow in and out of the country, then (as /u/Phage0070 noted), the country must buy (and destroy) or (create and) sell its own currency, in order to be a “market maker” that keeps the price within an “acceptable” range. Since their money supply is determined by market whim, they have lost control over their monetary policy.
* The alternative is to impose laws on currency traders within the country to ensure the desired exchange rate is maintained, and then to impose strict laws on the movement of currency, so that people can’t efficiently exchange the money overseas. This is what Malaysia did after the Asian Financial Crisis – they eliminated high-denomination banknotes, for example, and imposed strong limits on how much Malaysian cash a traveler could carry with them, as well as laws affecting banks directly.
* Most wealthy countries allow (relatively) free flows of money, and maintain control of their monetary policy – but that means their exchange rate is variable.
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