The world of foreign currency often seems confusing. Euro, rubles, yen and krona are terms difficult enough to comprehend on their own without adding the task of trying to figure out what each is worth in terms of United States dollars.
All of these currencies are money, so all serve the same functions. Money is a medium of exchange, a store of value and a measure of value.
As a medium of exchange, money is accepted as a means for purchasing goods and services. Both the consumer and producer agree to the form of money.
As a store of value, money can be saved for future use, a characteristic that many items used as barter goods did not have. Where crops would spoil or animals die, money lasts for a long period of time.
As a measure of value, money allows us to compare the worth of one object with the worth of another. We can say a car is worth so many dollars, and a CD is worth so many dollars.
Foreign currencies all serve the same three functions.
Now to the important question: How do we know how much any currency is worth? The simple answer is that money is worth whatever people are willing to exchange for it. This means it is simply a case of supply and demand. If there is little demand for a country’s currency and it is in large supply, the money will be worth less than if there is a high demand for it and a small supply.
As an example, if the United States buys more imports, there is a greater supply of U.S. dollars outside the country. As the supply increases, each dollar is worthless. Thus we say the money is devalued. If, on the other hand, there are relatively few U.S. dollars outside the country and/or many foreigners want U.S. currency, each dollar will be worth more.
Currency values and exchanges are usually made at currency markets. These are places where countries and banks can find out relative values of different currencies. Each day the values change, and often change several times during a single day. In the past, currency values were set at a rate and maintained for a period of time. Now supply and demand allow constant fluctuations.
The situation of foreign exchange is eased somewhat because many financial deals are calculated in United States dollars. At present, approximately 70% of all international trade is invoiced in United States dollars, because business people have found this practice easier. A hundred years ago when the British pound was the most important currency in the world, almost all transactions were recorded in British pounds.
Markets – Markets exist when buyers and sellers interact. This interaction determines market prices and thereby allocates scarce goods and services.
- An exchange rate is the price of one nation’s currency in terms of another nation’s currency. Like other prices, exchange rates are determined by the forces of supply and demand. Foreign exchange markets allocate international currencies.
Money – Money makes it easier to trade, borrow, save, invest, and compare the value of goods and services.
- Money is anything widely accepted as final payment for goods and services.
- People consume goods and services, not money; money is useful primarily because it can be used to buy goods and services.
- Most countries create their own currency for use as money.
Copyright © 2001, Revised 2006 The Foundation for Teaching Economics
Permission granted to photocopy for classroom use