Factors That Determine a Currency's Value

1 Introduction

Increasing exchange rate fluctuations, such as those that have occurred in the US dollar, have recently revived the discussion about the causes of such movements and the criteria for calculating the long-term over- or undervaluation of a currency.

Currency can be defined as any form of money that is in public circulation. Curren-cy includes both coins and soft money paper money. Typically currencies are used as a medium of exchange for goods and services. The exchange rate indicates the price of a currency and plays therefore an important role.

Also when investing or purchasing in a foreign currency, it is important to under-stand the factors that determine a currency’s value. Investors are often exposed to dif-ferent currencies, companies have overseas earnings, and many funds invest abroad. Exchange rate movements will therefore impact the returns of a business. In the following this paper examines several factors that influence a currency’s value.

2 Factors that determine a currency’s value

2.1 Inflation

The first aspect that influences a currency’s value is the inflation. Inflation can be defined as the overall general upward price movement of goods and services in an economy.

Inflation is being measured by the inflation rate. The inflation rate is determined by the percentage rate of change in price level over time and can be defined as follows:

Inflation rate = [P(t)-P(t-1)] / P(t-1)*100%

A larger amount of currency in circulation can lower the value of that currency. That means if the supply of goods and services does not increase or not increases as much as the supply of money, the prices for goods and services will go up.

Also when referring to inflation, Purchasing Power Parity plays an important role. PPP is being defined as “An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.”...