How is a currency value defined? How are projections made? What institutions take place in deciding the Representative Exchange Rate?


My country’s currency is devaluating rapidly against the dollar. $3.500 COP is projected to be 1 USD when it used to be $2.800 last year! I wanna understand the factors at play when I got tu buy or sell this currency, what decides the price.

In: Economics

The price of a currency is just like the price of anything else; it’s determined by a market.

The Foreign Exchange Market is where people go to exchange currencies. It’s populated by banks or bank-like entities, but those banks are just fulfilling orders from ordinary people and companies who want to, for example, trade COP for USD. The market matches these people up with others looking to make the opposite trade (USD for COP). The relative sizes of these groups determines the exchange rate. (As a side note the “Representative Exchange Rate” is just a summary measure of market activity. Over the course of the day, the market price might go up or down a little, but it’s useful to be able to say “the exchange rate yesterday was X” rather than having to recount that whole history minute-by-minute).

In your case, the market started at an equilibrium where 2.8 COP could buy 1 USD. Everyone who wanted to sell COP at that price could find a buyer, and everyone who wanted to buy COP at that price could find a seller. Then, more people who wanted to exchange COP for USD entered the market. If you maintained the old exchange rate, these people wouldn’t have anyone to trade with. To get more USD-holders into the market, the new sellers needed to start offering more attractive terms, and so the exchange rate changed to 3.5 COP per USD.

Why did more people COP sellers enter the market (or COP buyers leave the market)? That’s probably closer to the question you meant to ask. This could be related to how much of the currency is available – if the Colombian government is printing a lot, there will be more to sell on the market. It could also be related to economic fundamentals. How many people from Colombia are buying US goods? How many people from the US are buying Colombian goods? If some industry that Colombia excels in fails or fades, that’s going to reduce the value of the COP in the foreign exchange market. I’m not an expert in Colombian politics or economics, so I don’t have any guesses.