What Backs the United States Currency? By Mary Frazier,
United States currency does not have asset backing. Currency issued by the U.S. Treasury is fiat money, which is currency not backed by a commodity or asset, and therefore possessing no fundamental value. The value of currency comes from the free market system and government decree stating that currency issued is legal tender.
Historically, backing of U.S. and international currency was from the gold reserves of the country issuing currency. The U.S. gold standard began to breakdown during World War I, and continued to create economic problems until 1971.
Tying currency to gold created deficit problems for the U.S. and reduced gold reserves. Permanent abandonment of the gold standard began during President Richard Nixon's administration in 1971. The official end to the gold standard occurred in 1973, as many industrialized nations moved to a floating rate currency exchange system.
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A government declares fiat money to be legal tender, and the only backing of U.S. currency is the government's promise to honor the currency and pay. There is always a concern that a government will not be able to honor its currency, such as happens in countries that have severe financial or war crises.
The concept of "just print more money" has been around since the end of the gold standard, with much criticism. Opponents of currency not backed by a commodity like gold believe that a government can simply print money at will, which causes economic problems like inflation.
Floating Exchange Rate
U.S. currency operates on a floating exchange rate, where determination of currency value occurs through the free market system. The value of currency is determined by the market on the ability of a government to repay its debt. For example, a low priced or "weak" dollar indicates that the government has a high amount of debt or deficit. A higher valued or "strong" dollar signals that the economy is strong and able to repay debt.
Critics believe that a floating rate exchange and fiat money system create problems since currency is not asset-backed. However, when U.S. currency was on the gold standard, severe economic problems occurred that would again exist if reinstated. In a normal economy, central bank intervention keeps currency values in check.
When U.S. currency is over or under-valued, the Federal Reserve will intervene and buy or sell currency in the international currency exchange as needed to stabilize currency value. Timely intervention by the central bank keeps problems such as inflation under control. LINK
Why Do Exchange Rates Fluctuate? By Edwin Thomas,
A list of foreign exchange rates is a familiar site to travelers and anyone who studies the business news. The rate at which one country's currency can be exchanged for another changes, at least in small ways, on an hourly basis. Why exchange rates fluctuate, and what factors are involved, is not widely understood, even by people frequent travelers.
The foreign exchange rate is the amount of money you need to spend in one currency to purchase another. This process is frequently called "currency conversion."
The foreign exchange rate is set in most cases by activity on the foreign exchange market (FOREX or "currency market"). This market can only exist because of the prevalence of fiat currency. Unlike money that is made out of or backed by precious metals, fiat currency only has value because the issuing government says that it does.
However, there are some examples where the exchange rate is set by government order, and the currency is not allowed to "float" on the open market. China, for example, has a "managed" floating exchange rate, where supply and demand in FOREX influence, but do not determine the currency's exchange rate.
In actual practice, a currency's value is never derived solely on the basis of what a government says it should be. Instead, it is a mixture of what a government says it should be, what that government's fiscal policies are, the health of the country's economy and what people think the value of the currency should be. The latter gives rise to the practice of trading currency as if it were a commodity, and thus the foreign exchange or currency market.
So, for example, if a government is running a high, systemic deficit; has a weak economy; and is suffering a string of financial scandals, it will fall in value towards what the actors on the market perceive its real value to be.
State banks, private banks, and corporations will start selling that currency for more valuable or stable currencies, and speculators will begin betting against it. The result is a dumping of the undesired currency, and a scramble to buy up other forms of money. This is exactly what happened when the US dollar went into a record, downward spiral against the Euro, Pound Sterling, and Yen in 2007-2008.
The main benefit of the fiat currency system and its floating exchange rate is that market adjustments in value are usually more timely and less shocking than those dictated by a government.
Under the previous gold standard, government treasuries were often slow to adjust their currency conversion rates, and those adjustments were either too small or large and sudden by the time they were made. While FOREX is prone to distortion due to speculative pressure, most of the time it represents something close to the real value of a foreign currency.
The most heavily traded of the world's currencies are the U.S. dollar, the Euro, the British pound sterling, the Japanese yen and the Swiss franc. LINK
What Factors Cause Exchange Rates to Fluctuate? By Joseph Nicholson
The foreign exchange market, or forex, is one of the largest markets in the world, and is in constant flux. When it's night in one part of the world, it's morning in another, and exchange rates fluctuate as currencies are bought and sold.
With trillions of dollars' worth of currency trading each day, the currency market is one of the most important in an economy of global trade, and exchange rates fluctuate in response to a variety of factors ranging from economic data to changes in interest rates.
An exchange rate is a ratio that expresses the value of one currency in terms of another. An individual exchange rate is also called a currency cross or pair, and is identified by the abbreviations of the currencies involved. For example, EUR/USD is the number of dollars (USD) that can be purchased by one euro (EUR).
Indirect quotation occurs when the home currency is first in the pair. Direct quotation is when a foreign currency is listed first. The major currency pairs are EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD and USD/CAD.
Originally, currencies were redeemable in gold, silver or some other commodity of value. But demand for currency usually outstrips the available supply of such commodities, and lending institutions historically chased higher profits by lending more currency than they had in reserve. In the 20th century, the United States and other major countries abandoned the gold standard, leaving currencies essentially without intrinsic value other than the gross domestic product of each country.
In the most basic sense, currencies fluctuate because of changes in supply and demand. Supply of currency is usually based on the creation of money by national central banks, through a variety of means. The demand for currency can either be transactional, meaning it is needed for actual use in an economy, or speculative, meaning it is purchased simply because it is expected to appreciate in relation to other currencies.
The transactional demand for a currency is related to the economic growth of a country, its rate of employment, and the velocity of money, which is the rate at which money moves through the economy from one transaction to another. Speculative demand for currency is based on perceptions of the degree to which it will retain its value. This is related in part to expectations of future economic activity, but also to anticipated inflation, which occurs when the supply outstrips demand and sends the value of the currency down.
One of the most direct influences on exchange rates is the interest rate differentials between different countries. Central banks attempt to manipulate demand for their currency by raising or lowering benchmark interest rates, which represent the cost of borrowing in the currency.
The variation in interest rates around the world produces a type of speculative demand called a carry trade, where money is borrowed in a low-interest currency and converted and lent in a high-interest currency. The carry trader is able to keep the difference in the rates as profit, but runs the risk that changes in the relative interest rates and exchange rates will erode that profit. LINK
Factors Affecting Currency Value By Britt Barclay
Currency value can fluctuate in under a second. Unlike most measures of prices, currency is measured to the fourth decimal place; this varies from the common practice of measuring values to only the second decimal place. The value of currency depends on many factors, but they are primarily economic indicators, or reports that are compiled on key sectors of the economy. These factors include gross domestic product, retail sales, and the consumer price index
Gross Domestic Product
Gross domestic product, often referred to as GDP, is an extremely important indicator. Gross domestic product is used to measure the net amount of goods and services produced within a country during a year. Anything imported is subtracted from GDP, and all exports are added to GDP. GDP, in fact, incorporates some of the other factors that affect currency value.
Most experts have reached a consensus that a growth of around 3 percent per annum in real GDP is close to the ideal level. If the growth were lower, job growth would most likely drop to an unacceptable level, and larger corporations would struggle to make sufficient profits.
If growth were much higher it could spur fears of inflation. If the figures in predicted GDP and actual GDP vary too much, investors can become uneasy due to fear of high market volatility.
The fear of volatility can spread to all markets and not just the currency market. This can cause a drop in the valuation of a nation's currency as its economic stability is called into question. A stable rate of real GDP growth, on the other hand, indicates economic stability and can increase currency valuation.
The retail sales factor is exactly what it sounds like: It is the measure of sales within the retail sector of a country. Retail sales, although sometimes seasonal, can be a good indicator of the current status of the economy. Two sales reports are released: a cumulative sales report and a sales report excluding the sale of automobiles. The auto market is highly seasonal, so fluctuation in these expensive items can set off alarms unnecessarily.
The theory behind retail sales factors being influential is that the trends in retail sales can influence the policies of the central banks. The central banks' policy changes can then cause the economic growth rate and inflation to change. This will ultimately result in the changing of the value of currency.
Consumer Price Index
The consumer price index measures the average price for a standard basket of goods from year to year. The consumer price index is a key measure of inflation and arguably the most important factor affecting currency value. Due to the fact that exports are included in the consumer price index, many investors feel that fluctuations in these common consumer goods are indicative of changes in the strength of a country’s currency. LINK
Factors Affecting Currency Rates By Lindsay Tadlock
Currency is a unit of exchange used to transfer goods and services. Different countries use different currencies, and to exchange goods between two countries requires an exchange rate. Exchange rates vary daily--the U.S. dollar can increase or decrease in value compared to other currencies. Many factors affect currency rates, including the government budget, inflation trends, economic growth and stability, trade level of the country and traders' psychology.
A government budget has a huge affect on the currency value. If the country's revenue is more than its expenses, the government has a surplus and the currency rate increases. If the budget is in a deficit, the value of the currency falls.
An increase in inflation leads to a loss in value of a nation's currency. Inflation reduces the purchasing power and the demand for that currency. Sometimes however, if a country tries to control its inflation by increasing the short-term interest rate, the currency may strengthen.
Economic Growth and Stability
An increase in the currency rate can stem from a healthy economy. Countries with high levels of employment, retail sales and gross domestic product normally have a strong currency value. The stability or instability of an economy also affects the currency rate. An economy that is stable and financially sound will maintain a strong currency, while a country with an unstable economy will see a decrease in its currency value.
Demand for goods is shown from the trade flow between countries. This demand for goods reflects the demand for the currency of the countries trading goods. Trade deficits may have a negative affect on the countries' currencies.
When traders try to buy a strong foreign currency, demand for the currency increases, leading to an increase in the currency value. When traders believe a specific currency will increase in value, they buy; when the value does increase, they sell the currency, which results in an increase in supply. This inevitably results in the conversion rate beginning to decline. LINK