Can you imagine $5 trillion dollars? It’s a number so astronomical that it sounds fictitious. Except it’s not. $5 trillion is the estimated amount of money spent daily, around the world. How are most of this money traded? It depends entirely on currency strength. But what does it mean exactly? What makes one currency weak, while another currency is strong?
There’s a lot that goes into determining the value of a currency, and these factors can change overnight.
Here’s what you need to know about currency strength: what it is, what it indicates, how it works, and more.
What Is Currency Strength
It’s likely you’ve heard of currency strength before, but what exactly is it?
Currency strength is the relative purchasing power of a currency when traded against (or for) other currencies. Increasing the economic value of a currency will enable larger amounts of product purchases.
You may have also heard the term “purchasing power” to refer to a currency’s strength. Purchasing power refers to a national currency in the domestic economy. It’s the value of a specific currency expressed in terms of the number of goods one unit of that currency can buy.
Purchasing power is based on wage and income reports. Purchasing power can be eroded by inflation.
A strong currency is in high demand. It grows in value and is part of a stable economy. A weak currency is part of an unstable economy and declines in value.
Currency strength can also be measured by purchasing power parity or PPP. PPP is a theory that compares the costs of a typical basket of goods in different countries. PPP aids in comparing the standards of living in different countries.
Currency Strength as an Economic Indicator
A country’s monetary policy is controlled by the central bank of each country. In the U.S., the central bank is The Federal Reserve System (or simply, “The Fed”). The responsibilities of The Fed include regulating financial institutions, setting monetary policy, and more.
A central bank can reduce a currency’s strength by cutting interest rates.
Production of goods becomes accelerated when borrowing costs are decreased. Higher wages for employees lead to higher consumer spending. This leads to the inflation of consumer goods and higher corporate profits.
However, there are consequences to a currency’s strength remaining unchecked. It can inflate the cost of living, which in turn inflates salary demands, which leads to reduced profitability and expansion for companies. This in turn could lead to layoffs and high unemployment.
Of course, currency strength also affects a country’s international trade. A higher currency strength enables larger quantities of imported goods.
Currency Strength Factors
As previously mentioned, interest rates affect currency strength, with high-interest rates leading to a strong currency.
The stability of a government also affects currency strength. A stable government with a history of strong economic policies promotes investment, which in turn promotes a strong currency.
Government debt can also play a role. Governments with high debt are less attractive to foreign investors.
Finally, the current account balance of a country can also affect currency strength. The current account balance is the total amount of services, goods, income, and transfers of a country against all trading partners.
Currency Strength in Forex
Currency strength plays a huge role in forex or foreign exchange trading.
If you’re unfamiliar with forex trading, it’s when one currency is exchanged for another, usually for trade, tourism, or other commerce. The forex market is a global market.
On the forex market, currencies are traded against each other in what’s called a currency pair. You buy one currency and simultaneously sell another currency.
Currency pairs can exist as major pairs, minor pairs, exotic pairs, or regional pairs. A few examples of currency pairs include EUR/USD (Euro and U.S. dollar), GBP/USD (British Pound Sterling/U.S. dollar), EUR/CAD (Euro and Canadian dollar), and USD/INR (U.S. dollar and Indian Rupee).
This is where currency strength comes into play. Most forex trading is spot trading, which means trading currency pairs in real time. The first listed currency in the pair is the currency you are buying (the base currency), with the second the one you are selling (the quote currency).
This is where currency strength comes into play, informing what currency pairs you should buy and sell.
So if you notice the weakening of the US dollar, you may want to trade EUR/USD, where you are buying Euros and selling U.S. dollars.
Analysts use tools such as a currency strength indicator to determine the strength or weakness of a particular currency. There are many currency strength indicators or currency strength meters available to traders, with entire websites and apps devoted to helping forex traders make smart trading decisions.
While forex trading can be complicated, many traders start small. Many forex trading apps will allow you to begin trading with as little as $100. For more flexibility, consider upping your initial investment to a few hundred dollars.
The Importance of Understanding Currency Strength
Understanding currency strength can be complex. There are many factors that affect it, most of which are unknown or severely misunderstood by the average person.
However, if you’re interested in having a better grasp of global economics, or simply want to trade forex, understanding currency strength is vital. Without currency exchange, global trade would come to a halt.
For a better understanding of currency, trade, and economics, check out the finance and business sections on our site.
