How is it that currency have different value?

Question

If I want 500€ I need to pay 6000 SEK. What is it that decides which currency is the strongest? Like in Sweden the SEK is reaaally low right now. Why?

In: 0

Answer 1

It’s tough to think of supply, demand and prices for currencies because you measure prices in… currency. It’s weird. I find it easiest (and ELI5 appropriate) to think of currencies as tokens for an arcade.

Imagine you live in a town with three arcades. Each arcade sells their own tokens, but only a limited amount – maybe a few thousand every 3 months. If you can’t buy your tokens directly from the arcade, you have to hope that someone else in town has tokens to sell to you.

Now, which tokens would be the most expensive? If one arcade had the best games, then their tokens might be more expensive. If another arcade gives better prizes for winning games, their tokens might be more expensive. At the end of the day, though, the *price of the tokens is determined by how many people want to play at each arcade*.

That’s how exchange rates work: instead of arcades, we have economies; instead of games, we have investments; and instead of prizes, we have returns.

If a country has a strong economy that people want to invest in, their currency will appreciate (compared to other currencies) – people will be willing to pay more for the tokens that let them invest in that economy. If a country raises their interest rates (“better prizes”) compared to other countries, their currency will appreciate.

There are other effects this analogy covers, too: a lower exchange rate (cheaper token) helps a country with their exports (i.e., if all three arcades have the same game, people will be more likely to play the game at the arcade with the cheapest tokens); if an arcade issues more tokens, the price per token will fall (all else held equal) because there are more available. If a country goes through political instability (the arcade hires a manager that doesn’t clean the floors and smokes pot all day), the currency will be worth less.

Happy to get more into it if you’d like, but that covers most of the differences between currencies!