Determining the Price of Money in Forex Market

Forex market is more like an election in which people vote by trading a currency, and the totals are constantly apparent in the value of the currencies they buy or sell.

There was a time when most countries of the world backed all of their money with gold or other commodities. The Bretton Woods conference in 1944 placed the US at the center of currency exchange. However, all of this fell apart in the early ‘70’s, and modern currencies are almost entirely floating. What does this mean?

Quite simply, the value of each currency is determined by the consensus of the people who use it. So every person who uses dollars has an idea of what a dollar will buy and we agree on that value every time we make a transaction.

That brings us to the central question for the forex market—what determines this value and changes it from day to day? Economists and policy makers debate the finer nuances of these theoretical questions, and there are no simple answers. For the pragmatic purposes of forex trading, there are several major factors that make most of the difference.

The most fundamental factor is the money supply. To keep it simple, you might imagine the total value added to an economy every year (roughly GDP) divided by the amount of money in that economy (the total dollars). If you doubled the number of dollars in the system, that value would have to be split among twice as much money, meaning that the value of the money would become half.

As an economy slowly grows, it is only reasonable that the money supply should also grow. In fact, the interest rates maintained by the central bank force the money supply to grow slightly every year. If a government decides to print money freely, expanding the money supply at a fast pace, expect the value of the money to go down quickly—just look at Zimbabwe for an illustration.

The second major factor is the amount of investment or trade that is carried out in a given currency. Think of it this way: the value of the money is determined (crudely) by the value in the economy divided by the money supply. What if value rushed in from the outside? Said differently, what if foreign investors bought large numbers of dollars (or US bonds), sucking money out of the money supply? Naturally, larger value divided by the same number of dollars or the same value divided by fewer dollars means that the dollar goes up. This is exactly what happened with the Greek crisis. Fleeing the Euro, investors bought the dollar for safety. The immediate result was a drop in the Euro and a rise in the dollar.

Put all of this together, and the forex market looks more like an election in which people vote by trading a currency, and the totals are constantly apparent in the value of the currencies they buy or sell.

What controls the value of the currencies? The simple answer is the condition of the economies they represent: total value divided by the amount of money in the system. The more complex answer is what buyers or investors think about the condition of the economies. When you make a trade or an investment, you become part of that system. Believe it or not, you are what determines the value of the currencies you buy.

By Eric Kidder