How Does the Value of Currency Get Determined?

Fiat Currency

All modern monetary systems are based on the principle of fiat currency. This means that the value of money is derived not from any intrinsic value (as if it were made from precious metals) or the promise to redeem them for a set amount of precious metals but because the government dictates that it must be accepted as currency. The value of money is set by a mixture of what the government says it should be and what private and public speculators say it should be.

The Government

The government issuing flat currency takes the primary responsibility in setting its value. When a government prints fiat money, it is acting as a creditor in the sense that it promises the money is worth something. If a government does not back the value of its currency through an appropriate level of taxation, the money loses value. This is why budget deficits, national debts and central bank interest rates have an impact on what a currency is worth. Strong backing on the part of the public, strong economic performance and a healthy private banking sector can all mitigate this, however.

The Market

In the modern world economy, currency itself is treated as an investment commodity. The result is a speculative market where investors migrate between currencies seeking the convert capital into the best haven for their investment. This can cause a nasty feedback loop. A government with a weak economy, weak banking system or high budget deficits (or any of the above factors) will see the value of its currency erode vis-a-vis other currencies. This will cause money speculators to bet against it, driving it further down. The example of the sharp decline in the value of the dollar in 2007 and 2008 were good examples. Market speculation compounded the triple problems of weak economic performance, banking sector scandals and high budget deficits to produce a worldwide crisis in confidence against the U.S. dollar, driving it to records lows against most other major world currencies. This reflected the flight of private investors and foreign treasuries away from the dollar as the currency of choice.