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International Currency Markets

International Monetary System

Development of International Monetary System

Rates of exchange and purchasing power parity strengthen currency exchanges over international borders.

Though each country has its own form of currency, the collectively traded currency of the world follows the international monetary system. The international monetary system is a set of rules agreed upon by countries internationally in order to set monetary standards for trade between countries. Prior to World War I, all currency was compared to gold using the gold standard, or the establishment of gold as the underlying asset for all currency minted in a country. To convert from a domestic currency to a foreign currency, the domestic currency would first be converted to gold, and then the gold would be converted to the foreign currency. Because of shortages of gold after two world wars and the increasing availability of technological aids, currency is now converted directly between two nations using an established currency exchange rate. A currency exchange rate is the relative ratio of the value of a foreign currency to that of a domestic currency.

The transition away from the gold standard was made in 1944, when nations met at the United Nations Monetary and Financial Conference and redefined the way in which currency was traded. The Bretton Woods system established at the conference made the asset that backs national currencies either gold or the U.S. dollar. This made the U.S. dollar the "world's currency." The U.S. dollar is considered fiat money, a note that a government establishes, and backs the value of, as a valid form of payment by law. U.S. currency became fiat money in 1971.

In 1971 the United States stopped converting the dollar directly to gold, which eliminated the Bretton Woods arrangement. Because foreign currency exchange markets had increased in power and usage, by 1973 a modern exchange system took its place. Thus, in 1971 the United States declared the U.S. dollar a fiat currency that was directly correlated to the dollar being removed from the gold standard which allowed the dollar to float on open exchanges.

At the beginning of the 2000s, Europe underwent a sweeping change to its economy. In order to decrease currency fluctuations between countries and to promote trade, several European countries created a treaty to establish the euro area. They also established one currency: the euro. The euro is a currency used by the eurozone members of the European Union, a combination of European countries agreeing to one economic standard. A eurozone member is one of the current member countries of the European Union that have agreed to use the euro as their currency. This agreement assigned a single currency standard against which nonmember countries throughout the world would exchange.

A relatively new development in the international monetary system is cryptocurrency, a form of electronic currency that is not issued by a central bank. The best-known and most-traded cryptocurrency is Bitcoin. Since its development in 2009, Bitcoin is still considered new and unsupported; it is not backed by assets nor given regulatory oversight.

Development of International Currency Exchanges

Currency began as a barter system but evolved into a gold-backed standard. As gold became scarce, currency switched to fiat money.
It is easy to assume that each country's currency stands alone, but in reality international currencies are linked. Technology has changed the way that people look at international business. The foreign exchange market, or the currency market that is expressly used for trading currencies, operates 24 hours a day, allowing constant trading throughout the world. There was a time when exchanging currency was the province of large businesses and wealthy investors; now international trade is accessible online. Because of this, small businesses can now reap the benefits of international trade, but they must also bear the risks. Globalization has changed the face of a nation's domestic product and, by extension, the currency exchange rates between countries. Some economists see a future in which there is one global currency. The creation of the euro was a test run in this direction. Likewise, the use of credit cards globally is a huge step toward international currency.

Factors That Affect Currency Exchange Rates

The rates of exchange are driven by various factors, including inflation, purchasing power parity, currency appreciation, and political and economic risk.
Like any traded commodity, currency is governed by the laws of supply and demand. Because a country's currency is linked to its domestic products, demand for currency directly corresponds to the demand for products. Demand increases as the supply decreases when products in the given currency are purchased. When the supply of the currency matches the demand, it results in an equilibrium exchange rate, which is the point at which the supply of a currency meets the demand for that currency. Also because supply and demand change constantly, the equilibrium rate is remeasured to give the spot exchange rate. The spot exchange rate is the price to trade one currency for another at any given point in time.

Supply and Demand for Foreign Currency Markets

The equilibrium price is the point where the supply and demand lines intersect. At a spot price, the difference is the demand excess.
A country's currency is affected by economic policies and indicators. Inflation is one of the most significant economic factors affecting purchasing power between countries, and it is the primary motivator for international transactions. Inflation is the continual increase in the average price levels of goods and services, lowering the purchasing power of currency. According to the theory of purchasing power parity, a country with lower inflation relative to a foreign market will experience currency appreciation. Purchasing power parity (PPP) compares the relative ability of two different countries to purchase the same goods using their respective domestic currencies. Currency appreciation is the increase in value of one country's currency relative to another country's currency, generally because of economic conditions. Purchasing power parity states that items sold in two countries will have the same price when adjusted for the currency exchange rate. For example, Paul is a world traveler who specializes in eating for $10 per meal at Burgerton fast-food restaurants, where he always orders the same value meal. When he goes to France, he trades his $10 for 8.76 euros, which is exactly the price of the meal. Because the prices are the same, they reflect the purchasing power parity of the value meal.

The World Bank is an international organization, developed from the Bretton Woods agreement, devoted to providing financing and advice to developing nations. The World Bank constructs a comparison of purchasing power parity across countries every three years. The International Monetary Fund uses the World Bank's comparison for loans and analysis. The International Monetary Fund (IMF) is an organization consisting of approximately 190 countries that makes loans to developing countries or organizations within those countries in order to combat poverty. For example, in 2017 the IMF loaned 78 billion of its standard funds, listed as SDR, to Mexico, Colombia, and Egypt to assist in stabilizing their economies.

Because countries use currency supplies to change inflationary direction, political risks and economic risks are inherent in currency exchange. A political risk is generally associated with a change in the political landscape of a country. A political risk is the danger that shifts in government and political policies will unfavorably affect the currency exchange ratio at the time of the transaction. In the United States every four years there is a lag in investment trading as investors weigh political risks associated with the presidential elections. Economic risk is the danger that shifts in the economy will unfavorably affect the currency exchange ratio at the time of the transaction, resulting in real economic loss. This type of risk is less complicated and often occurs because policies have been put into place that affect the strength, or purchasing power, of currency.

Currency Exchange Rate Appreciation and Depreciation

Appreciation and depreciation of a foreign currency relative to a home currency can have an effect on the import and export of goods and inflation.
The amount that a foreign currency may depreciate or appreciate relative to a home currency can be calculated as a percentage.
Percent Change in Foreign Currency=[(1+Inflation of Home Currency)(1+Inflation of Foreign Currency)]1{\text{Percent Change in Foreign Currency}=\left[\frac{(1+\text{Inflation of Home Currency})}{(1+\text{Inflation of Foreign Currency})}\right]-1}
For example, if a home currency economy has an inflation rate of 5 percent and the foreign currency economy has an inflation rate of 2 percent, the expected change in foreign currency will be 2.9%.
Percent Change in Foreign Currency=(1.051.02)1=2.9%\text{Percent Change in Foreign Currency}=\left(\frac{1.05}{1.02}\right)-1=2.9\%
This is consistent with the international Fisher effect (IFE), a theory in economics stating that the expected disparity between two countries' exchange rates is the same as the difference in their interest rates. The appreciation can be calculated using a comparison of past and current spot exchange rates, which are currency exchange rates at any given point in time.
Percent Change in Foreign Currency=(Current Spot RatePast Spot Rate)Past Spot Rate\text{Percent Change in Foreign Currency}=\frac{(\text{Current Spot Rate}-\text{Past Spot Rate})}{\text{Past Spot Rate}}
If the current spot exchange rate is 1.15 percent and the most recent past spot rate was 1.03 percent, the percent change in foreign currency can be calculated.
Percent Change in Foreign Currency=(1.151.03)1.03=11.7%\text{Percent Change in Foreign Currency}=\frac{(1.15-1.03)}{1.03}=11.7\%
In this example the foreign currency appreciated by 11.7 percent over the time period in question. An appreciation of this rate will have a large effect on purchasing power. The goods and services offered by the country with appreciated currency will become more expensive to buyers paying with foreign currency. In global economies this can result in a negative effect on the import and export of goods. Conversely, the nonappreciated country will have cheaper exports. This can change the flow of goods, which changes inflation rates, which, in turn, change the currency exchange rate.