Foreign exchange trading involves profiting from fluctuations in the exchange rates between the currencies of different countries; but what causes the currencies to fluctuate against one another, and what gives money its value? In order to fully understand this, it’s important to know the difference between exchangeable commodities and fiat money.
In order to put this in perspective, it’s important to understand how people have exchanged goods through history. Humans have always bartered: this involved exchanging a certain amount of one type of good for an amount of another good at equal value. The problem with this system is the fact that it’s so cumbersome; one party in a transaction may need a certain type of good but not have the goods that the other party needs.
As a solution to this, parties to a transaction may exchange commodities that have an exchange value as well as a commodity value. The traditional commodities for exchange here are precious metals such as gold and silver; these have value in manufacturing, and can also be used as a token of exchange. For this reason, early monetary systems consisted of coins of a certain weight made from these metals. Silver coins, from the Old English Steorraling, or ‘little star’, form the basis of the British pound sterling.
While this was an improvement over bartering goods, the scarcity of the precious metals needed to make these coins lead to economic problems and a scarcity of currency for exchange. Seigniorage, the cost to actually produce the currency, was also an issue; sourcing and processing the precious metals that go into producing the currency made the process inefficient.
This has led to money as we now know it: a paper bill or coin of exchange that promises to pay the bearer on demand a certain amount of the precious metal that forms the basis of the currency.
In the US, this was known as the gold standard. Following the second world war, the pound sterling was tied to the US dollar under the Bretton Woods agreement until the dollar decoupled from the gold standard in 1971. Since then, both the dollar and the pound have been fiat currencies, from the Latin “it shall be”.
This allows governments to manage the value of the currency by matching the supply against demand. A shortage of currency during times of economic strife can be addressed by printing more; however, this risks devaluing the currency, as with the Zimbabwean dollar during the 2007 financial crash and the German mark during the Weimar Republic.
For forex traders, understanding that fiat currencies have no intrinsic value is important to knowing how currencies will behave. Being able to correctly predict how geopolitical events will affect countries’ economies and their currency is an important step in successful trading. However, traders should also remember that governments ultimately have control of the value of their currency through quantitative easing programs, so any fluctuations should even out to zero in the long-term.Tags: fiat, forex, forex trading