IT IS quite impossible to imagine human civilization flourishing without the concept and use of money and currencies. From the time when early men exchanged tools, food and other products with another to the present era of sophisticated and high-tech trading among nations and institutions, currencies have been the key drivers of social, political and economic progress.
The idea of a currency is pretty simple. Currencies are simply money in any form or object that can be freely exchanged for anything of value. The present day money: banknotes and coins are some of the best examples of a currency. However since anything of value that can be accepted as a form exchange can be considered a currency, then gold, oil and precious stones can be considered as currencies as well although these are not widely used as there are practical issues to consider such as storage, security and transportation.
In today’s globalized economy where countries transact with each other at the speed of electrons, money is no longer just an instrument to facilitate the sale and purchase of products and services. Currencies have become the objects or goods to be purchased and sold and are subject to market forces such as supply and demand.
In general there are three types of currencies: commodity currency, backed currency and fiat currency. A commodity currency’s value is determined by the value of the object itself (a gold coin’s value is determined by its purity and weight). A backed currency on the other hand is supported by a deliverable commodity of equivalent amount on demand (US$100 is equivalent to X grams of gold) while the fiat currency is backed by a guarantee of the issuer government.
Most countries maintain their own currencies for domestic and international trade purposes as well as for internal state expenditures. These currencies are created by law or what is termed as fiat currency, where it is the government through its treasury and central bank that create, circulate and regulate its use. Moreover, it is also the state that guarantees the value of the currency and manages it accordingly to ensure the stability of its financial and banking systems.
Since fiat currencies are the creation of the issuer governments, the values are ultimately determined by market forces where the political stability and socio-economic strength of that country are seen as crucial factors that affect price movements. A country involved in a war or experiencing political instability would expect their currency to be negatively affected.
A country’s domestic and international economic performance affects also its own and other currencies. There are three major economic-financial factors that affect demand or supply for a currency and ultimately its value, namely:
a.) Trade Flow
Trade flow is the flow of money in and out of a country as a result of international trade and commerce. When a country imports products from another the importer has to exchange or sell their local currency and buy the exporter’s currency to pay for the goods which are usually quoted in the exporter’s own monetary unit. This act of selling and buying creates demand for the exporting country’s currency (buying) while at the same time increases the supply of local currency (selling).
b.) Capital Flow
Capital Flow is the flow of money in and out of a country as a result of investments made inside and outside a particular country. If there is a lot of capital (money for investment) flow going inside a country, this situation creates demand for the host country’s currency thereby creating pressure to bring the value of such currency upwards. Likewise, if there is a lot of capital flow going out of a country, this indicates that there’s a low demand and rising supply of the local currency as investors are buying other currencies and disposing off their local currency holdings.
c.) Current Account
The sum of the balance of trade (exports less imports), interest and dividends from investments abroad and other inflows from expatriate remittances, grants or aid in any given time is called Current Account. Countries with Current Account surpluses normally experience the strengthening of their currencies while those with Current Account deficits will have a weakening of their respective currencies.