The way that currencies appreciate and depreciate against each other depends on certain key factors. Under today’s system of managed floating rates, currency values usually depend on market forces, political and economic factors, and the forces of supply and demand in the market rather than on fixed or pegged exchange rates.
In addition, the comparative rates of interest and inflation, as well as the cost of money in each country make up a large part of how a currency is valued in relation to other currencies.
Some governments and central banks also intervene in the currency markets to stabilize or manipulate the value of their currencies. See devaluation examples below.
Inflation and Printing More Money
Basically, the more paper money a country prints for its own internal purposes, the less the currency will be worth in relation to other currencies, because of an over abundance of supply.
In addition, if the fundamental political or economic climate of the country is uncertain, this would make that country’s currency a risk to hold, thereby driving the exchange rate lower.
Conversely, if interest rates are high in the currency’s country, then this will tend to attract investors and raise demand for the currency, thereby making it appreciate against other currencies.
Zimbabwe’s Measures to Control Inflation
Some countries attempt to deal with inflationary trends in their economy by manipulating their currency. As an extreme example, consider the devaluation of the Zimbabwe Dollar in 2008.
In 2008, the African nation of Zimbabwe had the highest rate of inflation in the world, with estimates for February of 2008 showing inflation in the African nation running at 165,000% a year. By May of that year, the inflation rate had gone up by some estimates to as high as 1.8 million%.
The Zimbabwe dollar, perhaps needless to say, could buy very little, and plenty of Zimbabwean dollars were needed with the exchange rate at 60,000.000.000,000,000 to one U.S. Dollar.
In order to deal with this massive inflation, the Zimbabwean government decided to devalue its currency by knocking off 13 of its 17 zeros, effectively making the exchange rate 6,000 to one U.S. Dollar.
Brazil’s Approach to Inflation
Brazil, always creative, has an interesting way of dealing with inflationary cycles in its economy. The country does not just devalue its currency, but reissues a new currency with a different name every time the inflationary spiral goes out of control.
In the 1980s, the Brazilian currency was called the Cruzeiro, until in 1986 the new currency which was introduced was called the Cruzado. After a few years, a new currency, the Cruzado Novo, or New Cruzado was introduced, only to be replaced in 1990 by the reintroduction of the Cruzeiro.
In another attempt to control inflation in 1993, the government devalued the currency by taking off three zeros from the Cruzeiro and naming the new currency the Cruzeiro Real.
After only a year, Brazil had devised a new monetary plan complete with a new currency, the Real which has continued as Brazil’s currency to the present day.
Both Zimbabwe and Brazil bear mentioning to illustrate the extreme measures governments can take with their currencies. Nevertheless, some solutions are really only short term remedies and do not solve the underlying economic problems.
Unfortunately, inflation must be addressed with painful fiscal measures which most governments simply would rather defer to the next government. This just makes the situation progressively worse.
Italy’s Approach to Inflation
The Italians now use the Euro, although, before joining the European Monetary Union, the Italians would simply allow inflation to push down their currency. This made prices seemingly high but really very much in line with purchasing power parity.
Before adopting the Euro, the Italian lira was worth 2, 200.00 to one U.S. Dollar. Thus, if a pair of boots in Italy cost 125,000 lira, the equivalent in U.S. Dollars would be $56.82, which would be in line with the price of a pair of boots in the United States.
The Italians did not adjust their currency, but rather let the currency continue to depreciate and devalue it in keeping with the inflationary tendencies of their economy.