Currency valuation method of any country?

Answer 1

The valuation of printed currency has always been of concern. The practice, before World War I, had been to link it to the sum of bullion held by the treasury (the so-called 'gold standard'). Net exporting econo-mies, accumulating forex (often as gold), would then find their currency's value rising; those with deficits would undergo the opposite. Meanwhile, currency and trade were private sector prerogatives, with official treasuries making requisite adjustments in terms of money supply (or coinage).

World War I and the Great Depression (1929) changed all that. The US and European economies all began experiencing increases in variance across inflation rates. That led Gustav Cassel, an economist of that era, to posit that exchange rate changes should account for differences in inflation rates. To him, terms like 'undervaluation', or 'overvaluation' were just a layman's way of saying that the going value of the exchange rate is inconsistent with the relationship that the domestic price level has with (comparable) prices ruling in a country's major trading partners. Cassel's 'purchasing power parity' (PPP) approach for determining a currency's 'correct' exchange rate was, thus, an attempt to devise a way for governments to set equilibrium currency values if they again wanted to peg to gold.

Market forces yielded place to 'policy-making' when PPP was followed by the 'elasticities approach' to balance of payments. That debunked devaluations, saying they would hardly help if the domestic demand for importables remained inelastic in the devaluing economy, while the demand for exportables in importing economies was price-inelastic too. The devaluing economy would then be left importing unchanged quantities - but at higher local-currency prices - while its exports (also unchanged) would cost less and fetch lesser amounts of foreign exchange! Hence was born the 'elasticity pessimism' doctrine. The policy prescription for avoiding such an impasse was that devaluing governments should also cut money supply to quell internal demand (or, 'absorption') to enlarge exportable surpluses. That was the 'absorption' approach to exchange rate determination. Policy-makers then had to either adopt the hard way of implementing a contractionary monetary policy by deflating the economy, or do just the opposite - and keep supporting demand and continue running up current-account deficits.

The answer to competitive devaluations, and ill-feelings all-round, was the post-War Bretton Woods Agreement (1944). A 'truce' of sorts, it pegged the dollar at $35 to 1 oz of gold, and set a rigid regime for remaining currencies. Devaluations, or otherwise, would have to be hard-fought, and after much convincing of the IMF board. But that suited Americans fine: It allowed them to fuel economic expansion with no fears of any downward pressure on the dollar! Thus, inflation was no problem for them, especially since they did not have to compensate for accelerating prices by interest rate rises. The dollar-gold parity-fix also induced capital account inflows since US dollar-denominated assets provided a 'safe' haven.

However, it all came apart over 1969-1973, after the US could no longer finance its trade deficits either through hard currency or gold. The final nail on the coffin of fixed exchange rates was hammered home in 1973. It is only out of self-interest, and a preference for predictability, that treasuries thereafter have tried to keep currencies within a restricted band against others. Within that, the US has distinguished itself by running up huge, and systematic, trade deficits - China being one of its biggest suppliers! Thus, it has long been lobbying for an upward 'correction' of the yuan's rate vis-a-vis the dollar.

Answer 2

One common currency valuation method used by countries is the floating exchange rate system, where the value of the currency is determined by supply and demand in the foreign exchange market. Another method is pegging, where a country's currency is fixed to another currency or a basket of currencies to maintain stability. Lastly, some countries use a managed float system, where the exchange rate is allowed to fluctuate within a specific range set by the government or central bank.