What Determines a Currency’s Value?

At the end of March the price of the euro in terms of US dollars closed at 1.1378. This was an increase of 4.7 percent from February when it increased by 0.3 percent. The yearly growth rate of the price of the euro in US dollar terms jumped to 6 percent in March from minus 2.9 percent in February.

 

1-EURUSDEUR-USD, 2007 – today, monthly – click to enlarge.

 

According to most experts currency rates of exchange appear to be moving in response to so many factors that it makes it almost impossible to ascertain where the rate of exchange is likely to be headed. Rather than paying attention to the multitude of factors, though, it is more sensible to focus on the essential variable.

As far as the currency rate of exchange determination is concerned, this variable is the relative changes in the purchasing power of various monies. It is the relative purchasing power of various monies that sets the underlying rate of exchange.

A price of a basket of goods is the amount of money paid for the basket. We can also say that the amount of money paid for a basket of goods is the purchasing power of money with respect to the basket of goods.

If in the US the price of a basket of goods is one dollar, and in Europe an identical basket of goods is sold for 2 euros then the rate of exchange between the US dollar and the euro must be two euros per one dollar.

 

The Money Supply and Purchasing Power

An important factor in setting the purchasing power of money is the supply of money. If over time the rate of growth in the US money supply exceeds the rate of growth of the European money supply, all other things being equal, this will put pressure on the US dollar.

Since a price of a good is the amount of money per good, this now means that the prices of goods in dollar terms will increase faster than prices in euro terms, all other things being equal.

 

Price Changes Do Not Occur All at Once, or Evenly

Changes in a local money supply affect its general purchasing power with a time lag, and this means that changes in relative money supply affect the currency rate of exchange also with a time lag.

When money is injected into the economy it starts with a particular market before it goes to other markets. This is the reason for the lag. When it enters a particular market it pushes the price of a good in this market higher. More money is spent on given goods than before.

This in turn means that past and present information about the money supply can be employed in ascertaining likely future moves in the currency rate of exchange.

 

The Demand for Money

Another important factor in driving the purchasing power of money and the currency rate of exchange is the demand for money. For instance, with an increase in the production of goods, the demand for money will follow suit.

The demand for the services of the medium of exchange will increase since more goods must now be exchanged. As a result, for a given supply of money, the purchasing power of money will increase. Less money will be chasing more goods now.

Various factors, such as the interest rate differential, can cause a deviation of the currency rate of exchange from the level dictated by relative purchasing power. Such deviations, however, will set corrective forces in motion.

 

The Role of Central Banks

We saw earlier that if the price of a basket of goods in the US is one dollar and in Europe two euros, then according to the purchasing power framework the currency rate of exchange should be one dollar for two euros.

But, let us now say that the Fed raises its policy interest rate while the European central bank keeps its policy rate unchanged. As a result of the widening in the interest rate differential between the US and the euro zone, the resulting increase in the demand for dollars pushes the exchange rate in the market toward one dollar for three euros.

This means that the dollar is now overvalued when compared to the relative purchasing power of the dollar versus the euro.

 

Demand for a Currency Is Affected by Attempts to Gain from Arbitrage

As long as this situation endures, it will pay to sell the basket of goods for dollars, then exchange dollars for euros, and then buy the basket of goods with euros — thus making a clear arbitrage gain. For example, individuals could sell a basket of goods for one dollar, exchange the one dollar for three euros, and then exchange three euros for 1.5 baskets, gaining 0.5 of a basket of goods.

The fact that the holder of dollars will increase his/her demand for euros in order to profit from the arbitrage will then make euros more expensive in terms of dollars — pushing the exchange rate back in the direction of one dollar for two euros. An arbitrage will always be set in motion if the rate of exchange deviates, for whatever reasons, from the underlying rate of exchange.

 

2-AMS growth differential-1Growth differential between the AASE US and euro area adjusted money supply (AMS). Note: money AMS is an “Austrian” money measure, which includes all the things that are money, but excludes credit transactions that lead to double-counting in official money measures such as e.g. M2. US money AMS is different from the TMS-2 measure we occasionally show here – it is a narrower measure (we would refer to it as TMS-1), which excludes savings deposits – click to enlarge.

 

Conclusion

All of these factors continue to affect the relative value of the US dollar to the euro. Relative to the euro, however, the US dollar is growing in value as the euro declines. After closing at 5.5 percent in June 2014, the money growth differential between the US and the euro zone fell to minus 4.8 percent in February this year.

This means that relative to the euro zone, US money growth has weakened significantly. From a monetary perspective, this suggests the US dollar will continue to increase in value against the euro in the months ahead, all other things being equal.

 

Charts by: Stockcharts, Frank Shostak / AASE

 

Chart captions by PT

 

This article has originally appeared at the Ludwig von Mises Institute and is republished with permission

 

Dr. Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics (AASE), provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, master’s degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.

 

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

One Response to “With Fiat Money, Everything Is Relative”

  • therooster:

    Everything is relative, yes …. well said. Fiat currency ultimately creates a real-time measurement system, one that does not have to measure in absolute terms but simply in relative terms (in real-time) so that we might be able to compare the measurement of value (dollars) for one debt-free widget against the value of another debt-free widget. The two widgets can trade for each other directly …. no debt involved.

    Gold is a debt free widget too and the dollar allows us to measure trade values with anything else that may be priced within the floating fiat model. This necessitates a bullion value that is variable to the dollar of course. Thank God for the watershed events in 1971

    It’s the floating value of USD/oz that bridges the yin to the yang within the emerging liquidity model of debts and assets .

    Just add assets and stir …. simple

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Canada: Risks of a Parliamentary Democracy
      A Vulnerable System Parliamentary democracy is vulnerable to the extremely dangerous possibility that someone with very little voter support can rise to the top layer of government. All one apparently has to do is to be enough of a populist to get elected by ghetto dwellers.   Economist and philosopher Hans-Hermann Hoppe dissects democracy in his book Democracy, the God that Failed, which shines a light on the system's grave deficiencies with respect to guarding liberty. As...
  • Federal Reserve President Kashkari’s Masterful Distractions
      The True Believer How is it that seemingly intelligent people, of apparent sound mind and rational thought, can stray so far off the beam?  How come there are certain professions that reward their practitioners for their failures? The central banking and monetary policy vocation rings the bell on both accounts.  Today we offer a brief case study in this regard.   Minneapolis Fed president Neel Kashkari attacking a block of wood with great zeal. [PT] Photo credit: Linda Davidson...
  • Thoughtful Disagreement with Ted Butler
      Too Big to Fail?   Dear Mr. Butler, in your article of 2 October, entitled Thoughtful Disagreement, you say:   “Someone will come up with the thoughtful disagreement that makes the body of my premise invalid or the price of silver will validate the premise by exploding.”   Ted Butler – we first became aware of Mr. Butler in 1998, and as far as we know, he has been making the bullish case for silver ever since. Back in the late 90s this was actually a...
  • Donald Trump: Warmonger-in-Chief
      Cryptic Pronouncements If a world conflagration, God forbid, should break out during the Trump Administration, its genesis will not be too hard to discover: the thin-skinned, immature, shallow, doofus who currently resides in the Oval Office!   The commander-in-chief - a potential source of radiation?   This past week, the Donald has continued his bellicose talk with both veiled and explicit threats against purported American adversaries throughout the world.  In...
  • The Donald Can’t Stop It
      Divine Powers The Dow’s march onward and upward toward 30,000 continues without a pause.  New all-time highs are notched practically every day.  Despite Thursday’s 31-point pullback, the Dow is up over 15.5 percent year-to-date.  What a remarkable time to be alive.   The DJIA keeps surging... but it is running on fumes (US money supply growth is disappearing rapidly). The president loves this and has decided to “own” the market by gushing about its record run. During...
  • Precious Metals Supply and Demand Report
      Fat-Boy Waves The prices of the metals dropped $17 and $0.35, and the gold-silver ratio rose to 77.  A look at the chart of either metal shows that a downtrend in prices (i.e. uptrend in the dollar) that began in mid-April reversed in mid-July. Then the prices began rising (i.e. dollar began falling). But that move ended September 8.   Stars of the most popular global market sitcoms, widely suspected of being “gold wave-makers”. From left to right: Auntie Janet...
  • On the Marc Faber Controversy
      Il n'y a rien à défendre - by Vidocq   Dr. Marc Faber, author of the Gloom, Boom and Doom Report Photo credit: Michael Wildi / RDB     Il n'y a rien à défendre - There is nothing to defend Personne n'a lu ce qui a été écrit. - Nobody read what was written. Personne n'a pensé avant d'agir, comme la plupart des gens de nos jours. - No one thought before acting, like most people nowadays. L'homme que tu pends est l'homme que tu as fait, pas l'homme que...
  • 1987, 1997, 2007... Just How Crash-Prone are Years Ending in 7?
      Bad Reputation Years ending in 7, such as the current year 2017, have a bad reputation among stock market participants. Large price declines tend to occur quite frequently in these years.   Sliding down the steep slope of the cursed year. [PT]   Just think of 1987, the year in which the largest one-day decline in the US stock market in history took place:  the Dow Jones Industrial Average plunged by 22.61 percent in a single trading day. Or recall the year 2007,...
  • Stocks Up and Yields Down – Precious Metals Supply & Demand
      Where the Good Things Go Many gold bugs make an implicit assumption. Gold is good, therefore it will go up. This is tempting but wrong (ignoring that gold does not go anywhere, it’s the dollar that goes down). One error is in thinking that now you have discovered a truth, everyone else will see it quickly. And there is a subtler error. The error is to think good things must go up. Sometimes they do, but why?   Since putting in a secular low at the turn of the millennium,...
  • The 2017 Incrementum Gold Chart Book
      A Big Reference Chart Collection Our friends at Incrementum have created a special treat for gold aficionados, based on the 2017 “In Gold We Trust Report”. Not everybody has the time to read a 160 page report, even if it would be quite worthwhile to do so. As we always mention when it is published, it is a highly useful reference work, even if one doesn't get around to reading all of it (and selective reading is always possible, aided by the table of contents at the...
  • Tales From a Late Stage Bull Market
      Pro-Growth Occurrences An endearing quality of a late stage bull market is that it expands the universe of what’s possible.  Somehow, rising stock prices make the impossible, possible.  They also push the limits of the normal into the paranormal.   This happens almost every time Bigfoot is in front of a camera. [PT] Cartoon by Gary Larson   Last week, for instance, there was a Bigfoot sighting near Avocado Lake in Fresno County, California.  But it wasn’t just...
  • The Falling Productivity of Debt
      Discounting the Present Value of Future Income Last week, we discussed the ongoing fall of dividend, and especially earnings, yields. This Report is not a stock letter, and we make no stock market predictions. We talk about this phenomenon to make a different point. The discount rate has fallen to a very low level indeed.   We add this chart to provide a slightly different perspective to the discussion that follows below (and the question raised at the end of the article)....

Support Acting Man

Top10BestPro
j9TJzzN

Austrian Theory and Investment

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com