How Is the Value of Money Determined & Exchanged?
Barter (i.e., trading) used to be the primary means of obtaining something you wanted. The barter system turned everyday items people had into rugged forms of currency, but the barter system was problematic because it wasn't easy for people to transfer, or exchange, from one "currency" to the next. Nations thus developed standard currency forms, the values of which are largely a matter of supply and demand.
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Interest
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Lending institutions of a nation, such as banks, typically get their funds from the nation's government. These funds may be backed by something tangible like gold, or the government may create them essentially out of thin air, such as the Federal Reserve does in the United States. The bottom line is that the lending institutions charge interest on these funds whenever they borrow from each other. Adrian Lowery of This is Money explains that when a nation's institutions provide high interest rates, other countries want to do business with that nation because they'll get a return on their investments through the interest. This means that there's more of a demand for that nation's currency, and the currency value thus increases.
Beliefs
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People apply their belief systems to currency value. Basically, this means that money has the value it does simply because people believe that the currency has that value. For example, if all Americans suddenly believed that $20 was worth $100, then the dollar would increase in value. In this way, there is a self-fulfilling prophesy aspect of finance. In addition, a nation may opt to engage in or deny trade to nations they see as a threat to their own ideals--for example, Americans may place embargoes on nations that advocate terrorism. This means that there isn't as great of a demand for that nation's goods, which influences the nation's interest rate.
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Trade (Supply and Demand)
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Lowery points out that trade (i.e., supply and demand) is one of the most significant factors that affect currency. He claims that, generally, as a nation exports more and more goods, the value of that nation's currency increases. This happens in part because nations adjust their interest rates to slow or stimulate economic growth.
Exchange Rates
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Exchange rates describe how many units of one nation's currency it takes to equal one unit of currency from another nation. They aren't set by any government or international organization, but instead are influenced by the economic factors of trade, interest and beliefs. Exchange rates thus are simple comparisons of value that are expressed in ratios; they are not determinants of value.
Considerations
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The factors that influence a currency's value and exchange rate don't operate in isolation. Beliefs impact trade, for instance, and trade impacts interest rates. Economists and governmental leaders who seek to improve the value of their nation's currency therefore have to take all three factors into consideration before implementing any plans for economic change. Otherwise, the plans may be less effective or even detrimental.
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