"So if your country doesn't produce much stuff, or at least not much for export, then your currency isn't worth a great deal and vice versa."
True, although there are other factors affecting the value of a currency. The most obvious is interest rates. Everything else being equal, holding cash is more attractive to an investor if he can get a higher rate of interest on it.
In fact, working out what makes exchange rates move is a complicated area of economics. There are a number of competing theories. In truth, they are probably all factors, and interact in highly complex ways:
1. Purchasing power parity. The idea that everything else being equal, identical goods should cost the same in real terms in different parts of the world regardless of the local currency, and that exchange rates will adjust to reflect this. After all, if they didn't, then surely it would always pay to change your money to another currency and buy the product at a favourable price. In practice though, there will be few goods that are perfectly interchangeable in different countries. And even where there are, the individual markets for those goods (not the currency markets) are rarely close to perfectly competitive.
This means that to some extent, if you were to find a particular product that was easily available across many different economies, you might be able to compare its price in local currencies, translate those into one particular currency and then see if a currency is over- or under-valued. Over the years, a number of such products have been suggested from the iPod to the IKEA 'Billy' bookcase, but the most famous is the 'Big Mac Index' published every year by the Economist.
2. Balance of payments. This theory would suggests that foreign exchange rates will adjust to compensate for the balance of payments surpluses or deficits of particular countries. If a country has a balance of payments surplus (that is, it exports more than it imports), then according to this theory the country's currency would increase in value. That would mean that its exports would become relatively more expensive and hence less competitive. And of course the opposite would theoretically apply for countries with balance of payments deficits.
3. Asset market. This model sees currencies in much the same way as any other asset and hence the market price will simply depend upon supply and (especially) demand from investors to hold that particular currency as an asset in their portfolio.
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dancing_serpent
(no subject)
Date: 2011-11-05 10:22 pm (UTC)"So if your country doesn't produce much stuff, or at least not much for export, then your currency isn't worth a great deal and vice versa."
True, although there are other factors affecting the value of a currency. The most obvious is interest rates. Everything else being equal, holding cash is more attractive to an investor if he can get a higher rate of interest on it.
In fact, working out what makes exchange rates move is a complicated area of economics. There are a number of competing theories. In truth, they are probably all factors, and interact in highly complex ways:
1. Purchasing power parity. The idea that everything else being equal, identical goods should cost the same in real terms in different parts of the world regardless of the local currency, and that exchange rates will adjust to reflect this. After all, if they didn't, then surely it would always pay to change your money to another currency and buy the product at a favourable price. In practice though, there will be few goods that are perfectly interchangeable in different countries. And even where there are, the individual markets for those goods (not the currency markets) are rarely close to perfectly competitive.
This means that to some extent, if you were to find a particular product that was easily available across many different economies, you might be able to compare its price in local currencies, translate those into one particular currency and then see if a currency is over- or under-valued. Over the years, a number of such products have been suggested from the iPod to the IKEA 'Billy' bookcase, but the most famous is the 'Big Mac Index' published every year by the Economist.
2. Balance of payments. This theory would suggests that foreign exchange rates will adjust to compensate for the balance of payments surpluses or deficits of particular countries. If a country has a balance of payments surplus (that is, it exports more than it imports), then according to this theory the country's currency would increase in value. That would mean that its exports would become relatively more expensive and hence less competitive. And of course the opposite would theoretically apply for countries with balance of payments deficits.
3. Asset market. This model sees currencies in much the same way as any other asset and hence the market price will simply depend upon supply and (especially) demand from investors to hold that particular currency as an asset in their portfolio.