Currency Valuation – the process of determining the value of one sovereign currency against another – is at the heart of all trade around the globe. Domestic prices and international prices are equally affected for every product or service rented, leased, purchased or traded.
Currency Value Comparison
The value of a currency has nothing to do with denominations within that currency system. It has everything to do with purchasing power. The greater the value of one currency – the purchasing currency – in relation to another currency – the supplying country’s currency, the higher its value relating to that currency.
For example, Chinese goods are purchased for import to Australia. The Australian importer determines when to purchase based on how strong the Australian dollar (AUD) is against the Chinese yuan. When more goods can be purchased for the same dollar, the importer purchases the goods. When the supply currency is worth more than the importing currency, the goods are more expensive. That price decrease or increase is often passed to consumers.
Currency as an Asset
When evaluating currency values, two currencies must always be used. Currency valuation entails comparing the strength or the purchasing power of that currency and determine how in demand it is in relation to another currency.
If, for example, the foreign exchange markets have solid ‘buy’ orders for the AUD but fewer for the US dollar (USD), the demand for the AUD rises when compared to the USD. More AUD is purchased for fewer USD: The currency valuation for the AUD:USD pair is in Australia’s favour.
Currency can be traded for any number of reasons: Businesses may purchase currency for trade purchase purposes. Government and individuals can stockpile currency for economic reasons. Traders purchase currency to gain profit from reselling it against yet other currencies when the exchange rates are favourable.
Currency is a commodity, just as oil, cotton, coffee beans, gold and food crops are. It can be bought, sold, stored or used. How much a currency is worth – the currency valuation – is always subjected to supply and demand, just like any other commodity.
Fiat v Commodity Based
With two exceptions in first half of the 20th century, most currencies values were backed by a real commodity, mainly gold or silver. For every currency unit or denomination, that currency piece was guaranteed in, for instance, gold reserves. The currency valuation could rise or fall but only if the backing commodity’s value rose or fell.
The amount of currency that could be generated by a country’s central bank was limited to the value of the backing commodity. If the currency system was backed by gold reserves, the total denominations of currency in circulation could not exceed the value of the gold reserves.
After WWII, the Bretton Woods exchange system set a relative exchange value based on the gold standard for currencies. One sovereign currency valuation could rise or fall against another, depending on other factors, but when Richard Nixon, the US president, removed the United States from the gold standard in 1971, the Bretton Woods system failed.
The USD was the base currency of international trade, and if it was not backed by gold any longer, the rest of the gold-standard currency could not directly tie value to the USD.
Since the Bretton Woods exchange system failed, the world’s currencies are fiat currencies – not backed by actual commodities and whose values are relative, and interpretation of value is often entirely subjective.
Currency valuation is fluid. One currency’s value changes from both internal and external reasons many times each day. A currency’s value can fall against one currency yet rise against another, but every item purchased, grown or traded is affected by currency valuation anywhere on the earth.