I’m reading about the changes in values of currencies at the moment, and I struggle to understand:
How are the values of currencies determined in relation to one another (e.g. EUR to GBP or GBP to USD), and why are some “stronger” than others?
I don’t understand why the GBP would be the strongest (or so it seems to me), followed by the EUR (although it’s recently been supplanted by the USD), and then the USD? With USA being the top economy in the world, and things like oil and gas traded in USD, why isn’t the USD the highest valued currency?
In: 3
The total value of all USD is much higher than all GBP. There are many more of them.
The actual value of a single one is relatively arbitrary – many countries which had high inflation introduced “new” currency that was the old one with a number of zeroes chopped off.
What matters most in the end, is how they move up and down compared to each other. If one somewhat consistently gains value compared to most others, it is a strong currency.
Currencies are traded. When you go to a foreign country you exchange your currency for the local currency. This is because local businesses only accept local currencies. Companies and governments also do this. It is not travel but a car company will acquire dollars from selling in America and then exchange them for the local currency to pay their workers.
The exchange rate depends on how many people want to exchange currencies. If more people want dollars than pounds then the dollar will go up in value relative to the pound. If a currency is being inflated then it will lose value relative to others that are not.
It’s sort of like measuring an elephant’s mass in grams and a mouse’s mass in kilograms. Even though the elephant’s mass is higher, the unit kilogram is much larger than a gram. Currencies can be similar (a large economy may have a very small currency unit or a rather large one. The size of the currency unit has no relationship with the size of the economy. When the unit is smaller, there are many more of them than in a nation with a larger currency unit.
When businesses sell products in other nations they usually get the local currency, but if their factories are in their home nation, they can’t use this currency to pay their suppliers and employees. So they trade currencies in markets made specifically for trading one currency for another.
The same is true when investors own assets in other nations (or when individuals travel to other nations).
Based on the number of people who want to buy a currency and the number of people who want to sell it, the prices fluctuate (in some cases the government buys and sells far more currency to maintain a fixed price but most currencies are allowed to trade at any price and the prices can be rather volatile.
How strong a currency is, mainly depends on the strength of the economy behind it.
Let’s take the US Dollar as an example, since you mention it. It’s strong mainly because the US economy is really strong (oversimplistic way of looking at it but it’s ELI5).
Its strength will be measured against the strength of another currency. For example, the USD could be strong against the GBP, yet weak against the JPY at the same time.
Generally:
* A strong currency is more stable and doesn’t fluctuate as much.
* A weak currency is linked with high rate of inflation, budget deficits, and slow economic growth.
When developing a currency there is an inherent advantage for a country that relies on imports to have a higher comparative value currency, and an advantage for an export country to have a lower valued currency. Using the US as a standard middle point things often pan out with this.
Let’s say it takes $1 USD of material to make a PB&J sandwhich. Congrats we have now pegged the USD to the PB&J standard. Now let’s go to Penutville where the cost of materials to make a PBJ is significantly cheaper due to all of the cheap peanuts, costing $0.5USD, but for those in Peanutville that is equivalent to 1P (1 peanut buck). Now let’s have the USA AND peanutville begin to trade PBJs with each other with $0.1USD taken up by transportation/etc, no other trading happens. Both value it at 1 of their currency, but the costs are significantly lower in Peanutville.The midway point after expenses between the two is $0.7USD, so let’s look at that impact. USA is now importing it and everyone gets to enjoy cheaper PBJ, the money saved from the cheaper PBJ can be used to buy other things, yay! Peanutville gets to export at a profit using the extra money to buy other things, Yay! Both parties are happy.
The midway point after expenses between the two is $0.7USD, over time Both currencies will converge and hit this point of equilibrium, and once that happens there is no longer an inherent savings/profit from a currency side of things.
Wasn’t life better when USA made savings and Peanutville made profit based on their differences? Instead of tying our currency to a strict PB&J standard let’s try to maintain the difference of our currencies through other means, like USA printing less cash, or Peanutville printing more cash. let’s balance some things out by including other nations and other trade goods.
Now let’s step back to reality, the UK and the EU import more than they export compared to the USA, so overall it is a net benefit for them to aim to have a higher relative currency value. Why is the Euro falling below the USD? They like the higher relative as it helps on imports, but now the cost of the imports has dramatically rose, and like a dam emptying it’s reservoir its using their initial currency advantage to purchase those goods. As the currency continues to drop the financial pains from importing will increase, but on the flip export industries get a relative boost.
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