How to compare currencies?

We all live in a world with different currencies and these currencies have different values of their own. So how do we derive the equivalence between them? In this post, we are going to discuss how we compare these currencies and derive equivalence between them.

If you haven’t read about money and currency you can read it here.

There are many currencies in the world such that there was a need to make a separate exchange where bets can be taken on different currency pair values. But why are there so many currencies?

The answer to this lies in the fact that each country wants to protect its own sovereignty. but with this, a bigger problem arises for people who move frequently move across borders, invest across borders, or take reference across borders for comparison.

There are two ways in which the equivalent value of a currency is determined with respect to other currency

1. Exchange rate of currency pairs
2. Purchasing Power Parity of currency.

So let’s go through each of them and understand what they are.

Exchange rate for currencies

So first of all what is an exchange rate? Simply put it is the amount at which you receive the exchange currency while giving up your current currency, it is very similar to buying something.

So for example if you are traveling to the United States of America from India, you will need to get USD to do transactions there, for this, you have to exchange your EUR for USD. So for exchanging the currencies the exchange rate comes into play. The currencies are exchanged at the current rate of exchange. According to the below image the EUR-USD exchange rate is 1.1364, so the euro will be exchanged at this rate.

it is to be noted that the exchange rate of currencies are decided on the forex and the currencies trade in pair on this exchange as shown in the above image.

But how are these exchange rates decided?

Exchange rates are influenced by a number of factors with varying impact on it. Some of them are listed below.

1. Interest Rates: Changes in interest rates affect currency. higher interest rates help lenders to generate higher returns than other currencies, and who does not want to earn higher returns on their capital. This then attracts people and boosts the demand for the currency leading to an increase of its exchange rate.
2. Inflation Rates: A country with lower inflation rates sees the value of currency depreciate slowly as compared to a country with higher inflation rates. This also makes the country’s goods and services more competitive internationally.
3. Public Debt: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. while such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors due to the risk of inflation and default.
4. Terms of Trade: A country’s terms of trade improve if its export prices rise at a greater rate than its import prices. This results in higher revenues, which causes a higher demand for the country’s currency and an increase in the currency’s value.
5. Current Account Deficits: A current account deficit shows the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. A deficit in the current account means the country is spending more on foreign trade than it is earning, and it is borrowing capital from foreign sources to make up the deficit.
6. Political Stability & Economic Performance: Countries with less risk for political turmoil are more attractive to foreign investors, as a stable political environment may have a positive effect on the country’s economy and help increase the value of its currency.
7. Speculation: if a country’s currency is expected to strengthen, investors will buy more of that currency in order to make a profit in the near future. this speculation can influence exchange rates just as much as actual movements in trade and capital.

It is to be noted that these factors are interrelated and can affect each other. For example, a rise in inflation rate of a country can hurt its currency’s value and reduce its exchange rates.

Purchasing Power Parity for currencies

Before discussing Purchasing Power Parity let’s understand what Purchasing Power and Parity mean.

Starting with Purchasing Power, it refers to the value of a currency expressed in terms of the number of goods or services that one unit of money can buy. Essentially, it represents how much you can purchase with a specific amount of money. It is the ability of money to acquire goods and services. It reflects the real value of currency in terms of what is can buy.

Factors affecting purchasing power:

1. inflation: high inflation erodes the purchasing capacity of money. As the price increases, the value of money diminishes.
2. Interest rates: high interest rates can also impact purchasing power. When borrowing costs rise, it reduces the amount of goods or services one can buy.
3. Exchange rates: stable domestic currency enhances purchasing power when traveling abroad.

One way to measure purchasing power is through price indexes such as the consumer price index (CPI) and the Producer Price Index (PPI). CPI calculates changes in the weighted average of prices for consumer goods services (including transportation, food, and medical care) at a given time.

Now Parity refers to the quality of being equal or equivalent.

How is the Exchange rate different from PPP?

Exchange rate is useful when there is an actual transaction happening, that is you are traveling or investing across borders, this is when the amount you have in the current currency is transferred to another currency.

Purchasing Power Parity is useful for comparison without actually realizing the transaction, that is it is useful when comparing the lifestyles in different economies because the cost of things is different in different economies on the basis of supply and demand.

This brings us to one of the important points which is to be considered while comparing the lifestyles. When we compare the lifestyles across different countries Purchasing Power Parity should be used instead of exchange since it takes into account the Consumer or wholesale product basket comparison, which helps in maintaining the standard of living while comparing.

This is all for this post. Hope you got to learn something. Don’t forget to follow my Facebook and Instagram page. See you all in the next post. Till then keep learning.