Different Ways of Determining the Value of Currency

Determining the Value of Currency: Theories, Demand-Supply Dynamics, and Modern Complexities

Introduction

The value of a nation’s currency is one of the most debated and analyzed issues in economics and finance. Currency valuation does not exist in isolation; it is deeply embedded in international trade, capital flows, macroeconomic stability, and public confidence. Governments, corporates, investors, and households are all directly affected by fluctuations in exchange rates. For instance, a depreciation in the Indian Rupee increases import bills for oil companies, while an appreciation of the US Dollar impacts developing economies’ debt servicing costs.

Historically, currencies were backed by precious metals (gold or silver standards), but in today’s fiat money system, currency values are largely determined by market forces, central bank policies, and global economic interactions. Predicting the precise value of a currency has become increasingly difficult due to the speed of capital mobility, technological disruptions, speculative trading, and sudden geopolitical shifts.

This article explores different ways of determining currency value, provides a detailed discussion of demand and supply of money, explains why demand for money is a derived demand, and illustrates modern complexities using case studies, numerical illustrations, and real-world corporate experiences.

I. Theoretical Frameworks for Currency Valuation

Currency valuation has been studied extensively under different theoretical models. Each provides a partial lens, but none can fully capture the complexity of modern foreign exchange markets.

1. Purchasing Power Parity (PPP)

The PPP theory is rooted in the “Law of One Price.” It argues that exchange rates should adjust such that identical goods cost the same in different countries when priced in a common currency.

Illustration:

Suppose a basket of goods costs ₹8,300 in India and $100 in the USA. The implied PPP exchange rate = ₹83 per USD. If the actual market rate is ₹90 per USD, the Rupee is said to be undervalued relative to the Dollar.

Global Example – Big Mac Index (The Economist):

The Economist’s “Big Mac Index” compares the price of McDonald’s Big Mac across countries. In 2023, the Big Mac cost $5.36 in the US and ₹240 in India. The implied exchange rate = ₹44.77/USD, while the market rate was about ₹82/USD, showing the Rupee undervalued by nearly 46%.

PPP provides a long-term anchor but often fails in the short term because of differences in consumption patterns, trade barriers, taxes, and non-tradable goods.

2. Interest Rate Parity (IRP)

IRP argues that differences in interest rates across countries are offset by forward exchange rate movements, ensuring no arbitrage opportunities.

Numerical Example:

US 1-year interest rate = 3%

India 1-year interest rate = 7%

Spot rate = ₹83/USD

According to IRP, the forward exchange rate should be:

F = S × (1 + i_IN) / (1 + i_US)

= 83 × (1.07 / 1.03)

≈ ₹86.25/USD

Thus, forward markets predict Rupee depreciation against the Dollar by 3.9%.

3. Balance of Payments (BOP) Approach

Currencies are influenced by trade and capital flows. A country with a persistent current account surplus (like Germany or Japan) tends to see currency appreciation, while chronic deficit countries (like Argentina or Turkey) face currency depreciation.

Case Example – Argentina (2023):

Argentina faced annual inflation exceeding 100%, a widening fiscal deficit, and dwindling foreign reserves. Result: Peso depreciated from 100/USD in 2020 to nearly 350/USD in 2023 in the parallel market.

4. Asset Market Approach

This approach treats currency as an asset whose value depends on expected returns compared with alternative assets. Investors evaluate risk-adjusted returns, inflation expectations, and policy stability before holding a currency.

Example – Japanese Yen:

Despite trade surpluses, the Yen weakened in 2022–23 because Japanese government bonds yielded near zero while US Treasuries offered >4%. Global investors shifted from Yen to Dollar assets, weakening the Yen.

5. Monetary Models

These link currency value with relative money supply and demand. If a country’s money supply grows faster than real output, inflation rises, leading to currency depreciation.

Example – Zimbabwe Hyperinflation (2007–08):

Excessive money printing led to trillion-dollar banknotes, making the Zimbabwean Dollar worthless.

II. Demand and Supply for Money

The value of currency is ultimately determined in markets by the intersection of demand and supply forces.

1. Demand for Money

Unlike demand for goods, demand for money is derived—people demand money not for its own sake but for what it can purchase (goods, services, financial assets).

Key motives:

a) Transactions demand – day-to-day needs (salary payments, purchases).

b) Precautionary demand – uncertainty about future expenses.

c) Speculative demand – holding money to invest in financial markets when opportunities arise.

Illustration – Indian Importers:

When crude oil prices rise, Indian refiners demand more US Dollars to pay suppliers. This raises demand for USD, putting pressure on INR.

2. Supply of Money

In domestic context, money supply is controlled by central banks (monetary base + credit creation). In forex markets, supply of foreign currency arises from:

Exports of goods and services.

Remittances.

Foreign Direct Investment (FDI).

Portfolio inflows.

Case – India (2021–22):

India received record FDI inflows of $83 billion, increasing dollar supply in the domestic market, temporarily stabilizing the Rupee despite a widening trade deficit.

3. Interaction of Demand and Supply

If demand for USD rises (due to higher imports) and supply does not increase correspondingly (exports stagnant), the USD appreciates against INR. Conversely, strong capital inflows can offset trade deficits.

Numerical Example:

Imports = $600 billion

Exports = $400 billion

Trade deficit = $200 billion

If FDI inflows = $220 billion, the capital account surplus covers the trade gap, keeping exchange rate stable.

III. Why Demand for Money is a Derived Demand

Demand for money originates not from desire to hold currency itself, but from:

Consumption needs (buying goods/services).

Production needs (corporates need working capital in currency).

Investment opportunities (holding money to invest later).

Thus, demand for currency is always linked to the demand for goods, assets, or services it can command.

Corporate Example – Tata Motors:

When Tata imports auto components from Germany, it demands Euros, not for their intrinsic worth, but to secure required components. Hence, the demand for foreign currency is “derived” from demand for imports.

IV. Complexities in Modern Currency Valuation

1. Speculative Capital Flows

Global hedge funds move billions in seconds. This speculative money often overwhelms trade-based flows.

Example – Asian Financial Crisis (1997):

Speculative attacks led to collapse of Thai Baht, followed by contagion across Indonesia, South Korea, and Malaysia. Despite healthy macro indicators, speculative withdrawal caused currency collapse.

2. Central Bank Interventions

Central banks intervene to stabilize volatility. However, excessive intervention drains reserves.

Example – Reserve Bank of India (RBI):

When INR depreciated sharply to 82–83 per USD in 2022, RBI sold nearly $100 billion from reserves to smoothen volatility.

3. Geopolitical Uncertainty

Wars, sanctions, and trade wars often move currencies more than fundamentals.

Example – Russia 2022:

Despite strong energy exports, Russian Rouble collapsed initially due to sanctions, only to recover later when oil/gas prices surged.

4. Technological and Algorithmic Trading

AI-driven forex platforms execute trades in microseconds, amplifying volatility. A sudden rumor or tweet can trigger billions in trades.

5. Cryptocurrencies – A New Dimension

Bitcoin and stablecoins are emerging as alternative stores of value, adding complexity. El Salvador adopted Bitcoin as legal tender, but price volatility made it risky.

V. Corporate Case Studies

Case Study 1 – Infosys Limited

Infosys earns more than 85% of its revenue in USD/Euro. A 1% movement in USD/INR directly impacts operating margins. The company uses forward contracts and options to hedge. In FY 2022, Infosys reported forex gains of nearly ₹1,200 crore due to Rupee depreciation.

Case Study 2 – Tata Steel

Tata Steel imports coking coal in USD but exports finished steel globally. A depreciation of INR increases input costs, but if global steel demand is high, export revenue offsets. The company manages through natural hedging.

Case Study 3 – Jet Airways (before suspension)

Rupee depreciation increased aviation turbine fuel costs (priced in USD). Combined with high debt, currency depreciation aggravated Jet Airways’ financial crisis in 2019.

VI. Country Experiences in Currency Valuation

1. India

Rupee has depreciated steadily from ₹8/USD in 1970s to ~₹83/USD in 2023, reflecting inflation differentials, structural trade deficit, and capital flow volatility.

2. Japan

Despite trade surplus, Yen weakened because of ultra-low interest rates. Carry traders borrowed Yen at low cost and invested in higher-yielding assets abroad.

3. China

China maintains managed float. The PBOC intervenes regularly to prevent excessive appreciation to maintain export competitiveness.

4. Turkey

Chronic inflation, unorthodox monetary policy (low interest rates despite high inflation), and political risks led Turkish Lira to depreciate from 1.5/USD in 2010 to >25/USD in 2023.

VII. Numerical Illustration – Predicting INR/USD

Suppose:

US inflation = 3%, India inflation = 6%

PPP suggests INR should depreciate 3% annually.

US interest = 4%, India = 7% → IRP suggests forward rate ~₹86/USD from spot ₹83.

But in practice, geopolitical tensions, oil price shocks, and capital flows make predictions imprecise. Actual rate might end up at ₹88/USD.

VIII. Challenges in Predicting Currency Value

Multiple determinants: Inflation, trade flows, speculation, central bank policy, and political risks overlap.

Short-term volatility: Currencies often overshoot fundamentals.

Black swan events: Pandemics (COVID-19) or wars disrupt normal models.

Asymmetric information: Market rumors and sudden policy changes lead to unpredictability.

IX. Conclusion

The determination of currency value is a multi-dimensional process. Traditional theories like PPP and IRP provide useful benchmarks, but in practice, demand-supply dynamics, speculative capital, corporate hedging needs, central bank interventions, and geopolitical shocks drive outcomes.

The demand for money remains a derived demand, rooted in the desire to purchase goods, services, and assets. Corporates, policymakers, and investors must understand these intricacies to make informed decisions.

In today’s interconnected world, currency valuation is less about precise prediction and more about risk management. Hedging strategies, diversified reserves, prudent fiscal policy, and regulatory oversight are essential tools to navigate the ever-volatile landscape of global currencies.