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.
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.
Growth 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.
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.
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”
Most read in the last 20 days:
- Modi’s Great Leap Forward
India’s Currency Ban – Part VIII India’s Prime Minister, Narendra Modi, announced on 8th November 2016 that Rs 500 (~$7.50) and Rs 1,000 (~$15) banknotes would no longer be legal tender. Linked are Part-I, Part-II, Part-III, Part-IV, Part-V, Part-VI and Part-VII, which provide updates on the demonetization saga and how Modi is acting as a catalyst to hasten the rapid degradation of India and what remains of its institutions. India’s Pride and Joy Indians are...
- US Financial Markets – Alarm Bells are Ringing
A Shift in Expectations When discussing the outlook for so-called “risk assets”, i.e., mainly stocks and corporate bonds (particularly low-grade bonds) and their counterparts on the “safe haven” end of the spectrum (such as gold and government bonds with strong ratings), one has to consider different time frames and the indicators applicable to these time frames. Since Donald Trump's election victory, there have been sizable moves in stocks, gold and treasury bonds, as the election...
- Global Recession and Other Visions for 2017
Conjuring Up Visions Today’s a day for considering new hopes, new dreams, and new hallucinations. The New Year is here, after all. Now is the time to turn over a new leaf and start afresh. Naturally, 2017 will be the year you get exactly what’s coming to you. Both good and bad. But what else will happen? Image of a recently discarded vision... Image by Michael Del Mundo Here we begin by closing our eyes and slowing our breath. We let our mind...
- The Great El Monte Public Pension Swindle
Nowhere City California There are places in Southern California where, although the sun always shines, they haven’t seen a ray of light for over 50-years. There’s a no man’s land of urban blight along Interstate 10, from East Los Angeles through the San Gabriel Valley, where cities you’ve never heard of and would never go to, are jumbled together like shipping containers on Terminal Island. El Monte, California, is one of those places. Advice dispensed on Interstate...
- A Trade Deal Trump Cannot Improve
Worst in Class BALTIMORE – People can believe whatever they want. But sooner or later, real life intervenes. We just like to see the looks on their faces when it does. By that measure, 2017 may be our best year ever. Rarely have so many people believed so many impossible things. Alice laughed. "There's no use trying," she said: "one can't believe impossible things." "I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for...
- Pope Francis Now International Monetary Guru
Neo-Marxist Pope Francis Argues for Global Central Bank As the new year dawns, it seems the current occupant of St. Peter’s Chair will take on a new function which is outside the purview of the office that the Divine Founder of his institution had clearly mandated. Neo-Papist transmogrification. We highly recommend the economic thought of one of Francis' storied predecessors, John Paul II, which we have written about on previous occasions. In “A Tale of Two Popes” and...
- Where’s the Outrage?
Blind to Crony Socialism Whenever a failed CEO is fired with a cushy payoff, the outrage is swift and voluminous. The liberal press usually misrepresents this as a hypocritical “jobs for the boys” program within the capitalist class. In reality, the payoffs are almost always contractual obligations, often for deferred compensation, that the companies vigorously try to avoid. Believe me. I’ve been on both sides of this kind of dispute (except, of course, for the “failed”...
- Trump’s Trade Catastrophe?
“Trade Cheaters” It is worse than “voodoo economics,” says former Treasury Secretary Larry Summers. It is the “economic equivalent of creationism.” Wait a minute - Larry Summers is wrong about almost everything. Could he be right about this? Larry Summers, the man who is usually wrong about almost everything. As we have always argued, the economy is much safer when he sleeps, so his tendency to fall asleep on all sorts of occasions should definitely be welcomed....
- Trump’s Plan to Close the Trade Deficit with China
Rags to Riches Jack Ma is an amiable fellow. Back in 1994, while visiting the United States he decided to give that newfangled internet thing a whirl. At a moment of peak inspiration, he executed his first search engine request by typing in the word beer. Jack Ma, founder and CEO of Alibaba, China's largest e-commerce firm. Once he was a school teacher, but it turned out that he had enormous entrepreneurial talent and that the world of wheelers, dealers, movers and...
- Money Creation and the Boom-Bust Cycle
A Difference of Opinions In his various writings, Murray Rothbard argued that in a free market economy that operates on a gold standard, the creation of credit that is not fully backed up by gold (fractional-reserve banking) sets in motion the menace of the boom-bust cycle. In his The Case for 100 Percent Gold Dollar Rothbard wrote: I therefore advocate as the soundest monetary system and the only one fully compatible with the free market and with the absence of force or fraud...
- Side Notes, January 14 - Red Flags Over Goldman Sachs
Red Flags Over Goldman Sachs Just to prove that I am an even-handed insulter, here is a rant about my former employer, Goldman Sachs. The scandal at 1MDB, the Malaysian sovereign wealth fund from which it appears that billions were stolen by politicians all the way up to the Prime Minister, continues to unfold. The main players in the 1MDB scandal. Irony alert: apparently money siphoned off from 1MDB was used to inter alia finance Martin Scorcese's movie “The Wolf of...
- Silver’s Got Fundamentals - Precious Metals Supply-Demand Report
Supply-Demand Fundamentals Improve Noticeably Last week was another short week, due to the New Year holiday. We look forward to getting back to our regularly scheduled market action. Photo via thedailycoin.org The prices of both metals moved up again this week. Something very noticeable is occurring in the supply and demand fundamentals. We will give an update on that, but first, here’s the graph of the metals’ prices. Prices of gold and silver...