The Language of Currency

Saturday July 4, 2009

When talking in money terms people often use phrases such as strong currency, weak currency, inflation, devaluation, recession and exchange rate markets or forex.  But what do these phrases or words actually mean in reality?

Do they have any relevance? Or have they just been concocted by people to confuse the issue and make it less straightforward?

Well, many of these terms are actually very descriptive terms that have been devised in order to explain something, using only one or two words, when otherwise it would take quite a few sentences to describe.  So, here is an explanation of some of the common terns that are used in modern day currency language to help get you started.

Strong currency

Currently, the euro is strong and it is commonplace to talk about strong currency.  In effect, if a currency is strong, then its value compared to various other currencies is quite high and usually improving, which means that it is getting higher.

So if the $ is strong, then it will be more expensive for people to buy dollars if they use the euro or any other currency, such as British sterling.

Because the euro is now a strong currency, if you have US dollars, you will be able to buy fewer euros with your dollars.

If you have a strong currency, then it will easier for a country to import goods, because they will not be so expensive and it will also be cheaper to travel abroad.

Investors can also benefit because they can usually buy any foreign stocks at lower prices.

Countries usually like to have strong currencies, but ironically they do not want it to be too strong, because too many imported goods could flood the market and make internal trade difficult.  So a stable currency can be as good as a strong currency, if not actually preferable to a currency becoming too strong and pricing itself out of a market.

Weak currency

Currently the US dollar is quite weak and many people are quite concerned about this.  But what does it mean in practice?

Well currency is weak, when its value compared to other currencies is relatively low and this does not improve over a few days or weeks.
Many currencies may have blips where on one day they are suddenly not worth as much as other currencies.  But if this only happens on one day, then a currency is not usually regarded as weak, it has to remain in this situation for a number of days or weeks.  A currency will then be regarded as weak.

The US dollar has been weak for a couple of years and this shows little sign of changing, for some time to come.  This means that the US dollar is not worth as much, when it is compared to other currencies.

A currency being weak is often not good for an economy because consumers and will find that prices on any foreign imports or services will be considerably higher and more expensive to buy.  It is also more difficult for all investors, because they are usually unable to expand their investments into foreign countries.  As a result, the country is often unable to stimulate growth within its own economy.  It is more expensive for people in a country with a weak currency, to travel abroad, since their currency will not buy very much for the money.  However, it is also cheaper for foreign visitors to come to that country.

Due to the fact that foreign goods will be more expensive to import, there can be a knock on effect, when the cast of day-to-day purchases rise and the cost of living gets higher.

Overall, a currency that is weak may not be a good thing for a country because it creates problems within the economy, due to its effect on trade.  If the weakness continues, then people start to lose confidence in the currency and as a result investors are more nervous about making long-term investments.  When this happens the economy may basically slow up.

Foreign exchange market

This is basically the foreign exchange market.  It is sometimes known as Forex or the FX market.  This is basically the biggest global financial market in terms of currency that exists.  It includes trading between governments, large banks, investors and central banks.  To give some kind of perspective to this market and related currency markets, every day the trait currently amounts to somewhere in region of  $3 trillion.
That is a serious amount of money.

The foreign exchange market works 24 hours a day, apart from at weekends and it takes into account all the currencies in the world.

The foreign exchange market is a particularly complex market because there are various different levels to it such as the inter-bank market, which is one level and then other levels incorporating small or investment led banks or commercial companies who need foreign money to be able to pay for items that they are exporting or importing.

Basically this market is the one that sets the value of currencies against each other and as such it is an extremely important market.

So the next time, that you change money from one currency to another, the rate you will get will have been set by the foreign exchange market.

Central bank

A central bank is sometimes referred to as a Reserve Bank or a Monetary Authority.  In the United States, the central bank is the Federal Reserve Bank.  In Britain, the central bank is the Bank of England.  In the European Union, the central bank is the European Central Bank.

A central bank is the bank that is responsible for implementing the monetary policy of a country.  So the government will establish the monetary policy and then the central bank puts this policy into practice.

One of its main responsibilities is to help maintain the consistent stability of any national currency as well as printing, issuing and circulating the supply of money to that local economy.

Most developed countries have a central bank that is independent from the government.  This is important because it means that there can be no political interference with regard to the bank or how monetary policy is implemented.  If the central bank and the government are ‘as one’ i.e. if they are not independent from each other, then the government would be able to manipulate the central bank for its own purposes.  This may happen if there were a dictatorship in any particular country and it may mean that the economy would suffer over the longer term as a result.  That is why a central bank must be independent from the government but obviously needs to work closely with the government, to ensure that there are no problems with regard to implementing the monetary policy.

Usually the central bank also has a responsibility to try and maintain steady interest rates.  The central bank will therefore make cuts to interest rates or will raise interest rates depending on which it thinks is best for the economy at that time.  This will be done in agreement with the government, but since the central bank is the expert in terms of money, any government will usually be wise enough to take its advice.

Recession

A recession is usually a term used to describe the situation where an economy fails to grow for six months or so, or where the Gross Domestic Product (this is how much a country earns every year through its trade and business activities) of a country starts to decline.  In other words, it is a period where the economy fails to grow and is not performing as it ought to be for a substantial period of time. 

During a recession, there is no growth in the economy and so there may be periods of inflation, businesses been unable to expand and there may also be a rise in unemployment and a decline in investment.  One factor alone, such as for example, inflation, does not mean a recession, but a combination of poor economic activities over some time, would indicate a recession.

Recession is worse than a few weeks of an economy not performing well and it is a sign of real and sustained economic stagnation.

Devaluation of a currency

Devaluation happens, when a government works with its central bank to deliberately lower the value of a currency with respect to other foreign currencies.  So if a currency were to be devalued, then it would be worth significantly less after devaluation, than before.  An example of devaluation is in Venezuela where the government devalued its national currency, the bolivar.  Prior to devaluation, one bolivar was worthless, because it could buy so little.  Then the government devalued the currency as a whole and established that 1000 old bolivars, would now be worth 1 new bolivar.

So effectively it said that the new currency was valued at one thousandth of the old currency.

Devaluation is quite an extreme measure for any government to take, because it obviously has a dramatic effect not just on the currency but on the country as a whole, as well as on the local economy.  Countries therefore will only devalue their currency when other economic measures cannot be seen to be working.  In a sense, devaluation is a last ditch attempt to stabilise an economy.

Due to the fact that it is seen as a last ditch attempt, governments will do their very utmost to try and ensure that they do not need to devalue a currency.  It really is quite an extreme measure.

Revaluation of a currency

Revaluation is basically the opposite of devaluation.  The currency is re-valued when its value in relation to other foreign currencies is raised.
For revaluation to take place, there has to be a fixed exchange rate, which is often fixed to other currencies or to something like gold.

The central bank can revalue the currency, but usually economists prefer for natural market forces to revalue the currency, by means of it becoming a stronger currency and therefore having a greater value when compared to other foreign currencies. 

Inflation

Inflation is basically when the price of day-to-day items, goods and services that people use, all increase over a period of time.  If only one set of items rise in price, then this is not regarded as inflation.  So the fact that the cost of food is rising, does not necessarily mean this is inflation.  Inflation happens when the price of everything rises and people cannot buy the same amount of goods one week for a set amount of money, that they could the previous week.

So if one week you could buy 10 items for $10, but the next week you could only buy 9 items (out of the same 10 items) for $10 and a week after you could only by 8 items for the same $10, then the economy is obviously experiencing a period of inflation.

Governments are always nervous about inflation because if left unchecked it can get seriously out of control as it has done in many countries throughout the world.  Germany experience significant levels of inflation during the 1920s and the currency became so worthless that there is a tale about a woman who fed banknotes into the fire, because it was cheaper to feed the notes into the fire, than buy firewood!  People even had to be paid on a daily basis, because the next day, their salaries would have effectively become worthless.

When inflation basically gets out of control, it is known as hyperinflation.
Usually, when hyperinflation takes hold of an economy it is in dire straits and it will require significant financial planning and drastic measures to be able to rectify the situation.  Hyperinflation is luckily quite rare, but Zimbabwe would appear to be reaching this level of inflation, due to its economic problems.

Inflation, when even at a low level impacts on people, because they are not able to buy as much with their money and so they tend to cut back on any unnecessary spending and as a result, economies can become quite stagnant, experiencing periods of slow growth and take some time to recover.

So inflation is not a desirable thing for any economy to have.

The IMF

The IMF is the international body that has a responsibility to oversee the world's financial system.  IMF stands for International Monetary Fund.  It is based in the United States and has been in existence since 1944, when it was set up to try and stabilise exchange rates and to make sure that there was some stability within global markets. 

The IMF is also the body that creates policies and procedures relating to the finances of the world and these are then implemented by the World Bank.

So the IMF sets the framework within which the World Bank must operate.

The IMF’s structure is made up of its members, who are all charged a quota to belong to the IMF and depending on how much quota they pay, they are given voting rights.  So the more quota a country pays, the more voting rights they have.

The IMF acts as a body to advise its 185 members about fiscal policies and how they can maintain stable economies.  It seeks to make it easier for international trade to take place, by removing any fiscal barriers that may be in place.  It is also keen to see sustainable economic growth on a global basis and that includes Third World and developing countries.

One of its main aims is to reduce poverty and it does this through making loans to Third World and developing countries, so that they can try to reinvigorate their economies and thus promote a better quality of life for their citizens.  It also has a role to play in terms of being a lender of last resort.  This means that if a financial institution, such as a central bank is experiencing such financial problems that no one else will lend to it, then the IMF will lend it money to try and prevent collapse.  So in effect it has a role as a safety net, for central banks throughout the world.

Given that the IMF was set up in 1944, it has experienced quite significant change in terms of monetary policies and the world itself has changed.  Some critics feel that it is not well equipped to deal with the rigours of modern financial problems and generally the IMF is having to go through a period of reorganisation in order to survive.

Any new currency, such as the euro has to be devised in accordance with IMF guidelines to ensure that it will be a relatively stable and secure currency.  It is obviously not in the interests of the IMF to have currencies floated, which then collapse after a only a few weeks or months, so it will work with countries to make sure this does not happen.

 

Comment

  1. Great information. I have a question regarding the Iraq Dinar, currently it trades at aprox 1million dinar equals about 1000usd. What happens if the dinar revalues to par ( for example) I would assume that they would trade the old currency for the new currency, then to usd if you wanted. is this correct? ie..1million dinar bought at 1000usd, dinar is now par, wouldnt the bank trade your old dinars for the new dinars first, resulting in about the same amount of 1000. I know there are several variables, but isnt that the jist of it
    thank you

    — Randy Young · Apr 5, 11:57 PM · #

 
 
 

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