It’s All About The Money, Honey!

(Basic Gyan On How Currency Value Is Determined) Posted on February 27, 2008. Filed under: Uncategorized | There are a lot of factors that go into determining a currency’s value. Let’s begin from the beginning. (Where else do you begin from!) Currency was basically created to serve as a medium of exchange. In the initial days, metals were used to represent stored value and symbols on them were used to represent commodities. This system had obvious flaws. There was no safe way to store the currency, therefore, it could be only as sound as the people who defended it. Basically, if you had a knife, you could make an offer no one could refuse. So a safe treaty was established for merchants, but it is now known exactly what was used as exchange. This system came to an end because of piracy. Then, during coinage, metals like gold and silver were mined, weighed, and stamped to assure the individual taking the coin that he was getting a certain known weight of precious metal. Our dear own Archimedes helped here in solving the counterfeit problem by helping test the fine weight of metal even if it had been tampered with. But the system had its problems. It became cumbersome exchanging thousands of coins. (imagine being Richard Branson or Bill Gates in that era, life would be so difficult managing vaults and vaults and vaults of money… not that they don’t do it now secretly.. ahem.. we won’t go there now). This resulted in the creation of paper money, commonly known today as bank notes. First, the mings and chings of China monopolized over issuing paper money. It was not until the mid 13th century that a standard and uniform government issue of paper money was made into an acceptable nationwide currency. Now, the problem was that, during that era was that one could be the James Bond of finance and literally have the ‘license to print money.’ Which led to having more money than commodities. (Imagine having unlimited money and limited commodities. Prices would rise so that only people who could pay more would buy – That’s what we call ‘Inflation’). Imagine having a balloon. You could blow only x amount of air in it. If you inflate the balloon more than its capacity, it would burst. The solution began evolving in the late 18th century with the creation of a central money authority with the monopoly on issuing currency. There were hitches in this system too, but they were slowly resolved with most of the industrializing nations on some form of gold standard, with paper notes constituting the circulating medium. Disclaimer: Intellectuals please continue reading, for the lesser mortals, you can suffice by knowing that prices will continue to rise and you will always fantasize that when you were younger things were cheaper, politicians were nicer and the world was a better place. Now, where were we… ah…value of money today. Things get a little complex with the term ‘exchange rate’. This says that ‘A currency’s value is determined based on its comparison with another currency.’ For example, if one bag of potatoes cost Rs.10 in India and 50 cents in US, then it is concluded that Rs.10 is equal to 50 cents. This is called purchasing power parity (PPP) by the people in the business.

Sweets. As for the potatoes. if there are large inflows of foreign money into India. If it’s floating. In other words. Inflation (the term is to refer the unlimited money and limited commodity problem earlier) will also play a role in determining the value of the currency. if the inflation rate in India is expected to be 5% in the next 12 months and 2% in the US for the same period. the currency becomes stronger and vice-versa. the rupee would have depreciated against the dollar.There can be two scenarios: The exchange rate can be fixed or floating. For example. Typically. potatoes might cost Rs. a currency rate is determined by multiple factors like economic growth. ‘international market forces’ (I don’t mean the CIA by that) decide the rate based on various factors. I have enough complex information to write a book on this. If more people buy the currency. while they would cost 51 cents in the US. inflation rate and demand for the currency. . go easy on them. For example. strength of the economy.10. it increases the rupee value. There’s more gyan on free floating currency and movable or adjustable peg system of fixed exchange rates. I’m going to stop here.Exchange rates between two countries can be fixed based on a monitory policy they maintain. and that money gets converted into rupees.50ps in India next year. and since this borders on basic gyan.

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