Foreign Currency
Overview
In order for a nation to conduct commerce with itself and with other regions, it needs a unit of exchange that serves as a universally recognizable funding for use in trade: currency. Since ancient history, civilizations have crafted their own nationally-accredited currencies which, until only recently, were usually based upon commodities of intrinsic value. In the Roman Empire, for instance, armies typically received payment for their service in the form of salt which, as a food preservative, had intrinsic value beyond that which was declared upon it. And even in our recent past, many nations have used universally-regarded precious metals to back the paper and coin currency species they produce --- until the 1970s, the United States used gold to provide fundamental meaning to the dollar.
Yet the world of foreign currencies has changed significantly in just the past few decades, reflecting a society with an increasingly high affinity for global trade. Although not as stable in some cases when compared with former practices, the new mechanisms allow for the rapid exchange of resources across geographic and political boundaries in order to support the demand for goods that has resulted.
Valuation
The tendency is to assume that a US dollar, Euro dollar, yen, or any other currency is worth exactly what it is stated to be and that little change will occur to influence that value. However, while it is true that one can physically hold, for instance, five euro dollars, the valuation of that amount is in constant yet gradual change. Currency is like any other commodity in existence in the world: there is a certain supply and a certain demand of each type. Based upon the interaction of these two attributes, a currency’s true value is determined accordingly.
Sometimes, however, a currency is not its own commodity, but rather, a representation for a small supply of another (as stated earlier, the United States used to back the dollar with the gold standard). But as an economy expands and seeks true economic independence, such backing is impractical: first, there is seldom adequate backing commodity available to consistently fulfill demand; second, a nation’s backed currency varies not by its own economic capacity, but by the worldwide demand for its backing commodity. It is therefore clear why many nations have moved to more independent approaches to valuating their currency given that it allows a country to represent its true economic vigor.
Exchange Rates
While many currencies are no longer officially backed and hence have very little implicit value, each country’s specie must be able to be exchanged for something that is intrinsically desirable. This is usually accomplished through a healthful system of international trade that awards the largest quantity of a nation’s currency to the foreign entity with the most appealing set of products or services and thus the region with the strongest perceived economy and the strongest relative currency. Beyond this general science, however, there are two approaches to equating currency value between nations.
The first of these is the floating currency model which, as the name suggests, adjusts frequently to account for subtle changes in a nation’s economic wellbeing. Factors that usually influence the supply and demand relationship of floating currencies include the degree of foreign investment in the specie, import/export ratios, inflation, and outlooks regarding a country’s perceived future. Of the two exchange rate systems, the floating currency type is usually employed by large and stable economies where it is highly unlikely that a single event could cause a catastrophic economic situation (e.g., the United States, Canada, Great Britain, etc.).
For smaller nations, however, a fixed or “pegged” system is more appropriate. Such an arrangement allows a country to define a fixed conversion factor for its specie based upon another currency of a larger economy (usually one that operates under floating currency exchange rates). However, a country cannot select an arbitrary amount for this value as no currency is exempt from the supply and demand implications upon commodities. Rather, a nation must give prudence to the amount it selects and adjust when appropriate so that it can be a part of the $1 trillion in foreign currencies that are traded each day.
 |
Members of the European Union found that by standardizing their currency under a single unit, the Euro Dollar (above), that they would build a strong currency and a high profile international image. |
In some cases, nations have found that consolidating multiple currencies to a common unit has the tendency to increase overall valuation; the Euro dollar is a strong example of this. When the 12 member countries of the European Union merged their currency to a single unit (the “Euro”) at the beginning of 2002, they launched what has since become the second most powerful currency on the globe. Economists credit this power to the fact that the Euro dollar condenses multiple economies so that they function as almost a single entity. This works largely in favor of economic power in western Europe, but can also work against more economically successful EU members given that potentially stronger economies are forced into a more limited arrangement. Nonetheless, the equity added via currency standardization is substantial enough to offset a large amount of this possibility, thereby increasing currency valuation further beyond the collective sum of the original constituents.
No matter what approach a nation (or group of nations) chooses to pose its currency to the global marketplace, there is --- at the end of the day --- an exchange rate between one currency and every other. To demonstrate this fact, the following applet has been developed to allow you to convert currencies based upon their real-time exchange rates. Try converting several values to see how one currency stacks-up to another, or provide your own conversion factor. Additionally, a set of 30-day, real-time summary charts of five leading currencies (the US Dollar, the Euro Dollar, the British Pound, the Japanese Yen, and the Australian Dollar) have been made available below to show how economic powers are shifting in the world right now. Change is happening --- watch it as it occurs!
