While it might be difficult to understand precisely how certain countries choose to use one currency or another, there are usually clear reasons why a specific country chooses to use its currency or share a currency with other countries. Some countries use their currency, whose value is pegged to other, more stable currencies.
Let’s look at how countries decide to use one currency or another and how it affects its value.
Who decides which currency is used in each country?
Each nation chooses the currency it will use, and by having its currency, it can control interest rates, the money supply, and the currency's strength to meet its goals and objectives. Therefore, each country has its currency that is different from the others, rather than using a single currency.
An exception to this rule is countries included in the European Union. The establishment of the European Union created a single, multi-nation financial system using the euro as its official currency. Despite this fact, some European countries still use their currency because it allows them to have more control over price stability and control their trade balance.
Other countries rely on foreign currency to conduct trade because their currency has progressively lost its value. Countries riddled with high inflation force their constituents to use a foreign currency, usually the US dollar, to conduct trade.
Value of a currency
The demand and supply for a specific currency will influence its value, and it is usually dependent on a country’s trade balance. A country that exports many goods and services will naturally have a higher demand for its currency because buyers need to use the currency to pay for those same goods and services.
However, the country itself may not want its currency to have a high value if it relies on exports because the higher the currency's value, the lower the exports will be. Similarly, a country that relies heavily on imports needs a strong currency so its citizens and companies can continue importing goods and services.
Additionally, a currency’s value is determined by the people’s faith and trust in the currency. In situations where that trust is lost, other currencies that are more stable and able to hold their value are used instead.
Who controls the exchange value of currencies of different countries?
While it may seem like the exchange value of currencies of different countries is controlled by an entity or several entities, the reality is that this value is determined based solely on supply and demand.
A currency that is highly demanded will naturally have a higher value, and a currency with lots of supply will tend to have a lower value. Additionally, some factors influence the exchange rates of each country:
Inflation is a general increase in the price of goods and services, varying from country to country. Beyond this simple definition, what inflation does is that it lowers the value of a currency because you cannot buy the same goods and services since the currency is worth less.
Inflation can hurt the value of a currency, and it can affect exchange rates across the world. Additionally, a high level of inflation can reflect an oversupply of currency. If this is the case, the value of that currency will be lower when compared with other currencies.
Interest rates determine the cost of capital or the cost of money, and they are one of the most critical factors affecting the value of currencies. If interest rates are high, the cost to borrow a specific currency is higher, and therefore its value tends to be higher. Conversely, when interest rates are low, the cost to borrow the currency is lower, and therefore the exchange rate is expected to be lower.
Central banks frequently think about changing a currency's value to affect the state of the economy. To raise the demand for American goods, for instance, the U.S. central bank would want to weaken the dollar. This will help the economy. However, a declining level of international competition can result in U.S. inflation and lower imports.
Who decides the value of money?
The value of money is decided through supply and demand by assessing a currency's ability to be converted into other currencies. Most of the world's currencies have adopted one of two exchange rate schemes after the termination of the gold standard in 1971.
Here are both exchange rates systems:
- Fixed Exchange Rate
When a nation ties its currency to an anchor currency such that both move in lockstep, this is known as a fixed exchange rate or a currency peg. Most nations that choose a fixed exchange rate are developing nations looking for monetary stability.
The US dollar is the most widely used anchor currency since it is comparatively stable and regarded as a haven during times of crisis. The disadvantages of a fixed exchange rate include lost policy autonomy, less liquidity, and reduced free trade.
- Floating Exchange Rate
Allowing the foreign exchange market to decide a currency's value depending on the supply and demand of other currencies is known as a floating exchange rate. Countries operating under a floating rate system could see increased exchange rate volatility, but they also gain more control over their trade and economic policies and more liquidity. The government occasionally steps in to maintain the currency rate fluctuating within acceptable bounds.
How does a country buy its currency?
A nation's central bank can intervene and attempt to control the exchange rate by increasing demand for the currency if the value of that currency begins to decline on the international market.
By using the foreign money, it has on hand in reserves, the bank can purchase its currency. This stops the currency's decline and limits the amount of money in circulation by lowering the amount in use. The same holds if the central bank decides to sell its currency in response to an excessive currency appreciation.
Who controls the national currency of a country?
Each country controls its national currency through its central bank. They can increase or decrease the money supply and control the interest rates, which define the cost of money. This helps countries control the demand and supply of their currency in a way that is advantageous.
One of the most important considerations for any country and currency is its trade balance with other countries. So, for example, a country that relies on exports could devalue its currency to increase exports. In the same way, a country that is reliant on imports could try to make its currency as valuable as possible so that it can import more goods and services.
Does the government control the currency?
While a government does not have complete control and oversight over its currency, it has a say in policy and legislation that can affect its value. Only the central banks can have some control over a specific country's currency, but a central bank is an independent entity from the government. Therefore it does not make any decisions based on the government.