IF EVERY COUNTRY in the world used the same currency, international trade would be made much easier. Unfortunately, this is not the case: a Copenhagen beer producer wants to be paid in Danish koner, and a Hong Kong shirt maker wants to be paid in Hong Kong dollars
What is a currency worth? Currencies, like other commodities, such as beer and shirts, have a certain value. The only difference is that each currency's value is stated in terms of other currencies. French francs have a value in U.S. dollars, which have a value in British pounds, which have a value in Japanese yen. These exchange rates change constantly, depending on the market for them, and are updated constantly in banks and foreign exchange offices around the world.
These "forex" markets keep track of the values of all of the world's major currencies. As some increase in value, others decline. When a French franc goes up in value against the U.S. dollar, the dollar must go down in value against the French franc. At the same time, the French franc may decline in value against the British pound, meaning that the dollar declines even more in terms of the pound. Foreign exchange is a constantly changing twenty-four-hours-a-day market, with trading in hundreds of financial centers around the world, from Singapore to San Francisco and from London to Buenos Aires.
These markets are all linked electronically. Banks and "Bureaus de Change" look at this global interbank market to set their daily rates. When we change money while on vacation— whether we are in Florence, Tahiti, or Acapulco—the exchange rate is determined by the global market.
Anyone traveling abroad will notice that the exchange rate is slightly different if the customer is buying or selling any one particular currency. This "spread" between the buy and sell rates ensures that the banks and exchange bureaus make a small profit on every transaction. This means that an indecisive traveler, by exchanging money back and forth several times, would end up with a lot less money, after losing a few percentage points in spreads and commissions on each foreign exchange transaction.
How do the foreign exchange markets decide how much a currency is worth? The prices of freely floating currencies are influenced by economic and political events and sometimes by the speculation of individual traders. Foreign exchange traders, like traders in grain or pork bellies, sometimes "bet" that a currency will increase in value. If interest rates fall in Tokyo, traders may rush to sell yen and buy dollars, hoping to get a higher return on their investments. If the Swedish economy looks strong, the krona may increase in value; but if it looks as though inflation is returning, the krona may decline against currencies with longer inflation.
Likewise, during periods of economic and political turmoil, the world's traders and investors often turn to a particular currency as a refuge. When political or social unrest threatens currencies around the world, traders and investors often rush to buy "hard" currencies such as the Swiss franc and the U.S. dollar, which are expected to preserve their value in times of trouble.
From Randy Chase Epping: A BEGlNNER'S GUIDE TO THE WORLD ECONOMY, Vintage Books 1995.