What are the factors that underlie currency exchange values in a free market?This is an International economics question.
I think that the previous thoughts were very strong. Along those lines, I think that currency exchange values represent the overall strength and sustenance of an economic system. Currencies that enjoy strong values reflect the value of overall presence and strength in the world economic order. The perception of the nation and the support of its currency is a positive one. When examining the dynamics between two nations' changing currency values, it might also reflect a changing relationship between both nations' economic systems. For example, when the Indian Rupee started gaining a bit of value against the US Dollar, many economists attributed the change to the new globalized dynamic that emerged between both nations in terms of trade, employment, and a more balanced economic relationship between both nations. This was highlighted by the currency exchange value between both economies.
The main factor that underlies the currency exchange values is the relative levels of supply and demand for the currencies in question. When there is strong demand for a currency, all other things being equal, the exchange value of that currency goes up.
The demand for a currency is generally dependent upon how many of that country's goods and services are desired by other countries. When Country A wishes to buy goods or services from Country B, it must buy Country B's currency first and use that currency to buy the goods or services.
So you might say that a currency is strong if there is demand for it and that there is demand for the currency if there is demand for goods and services produced by that country.
Currency exchange values or exchange rates refer to the price of one national currency in term of some other national currency. For example; presently one US$ can be exchanged in the international markets for about 45 Indian rupees.
The exchange rate are determined primarily by the relative demand for different currency. This in turn is reflected by the purchasing powers of the currency as well as government. If there is a greater demand for Japanese goods in the US then this will tend to push up the price of Japanese yen in terms of US$. A system that allows the exchange rates of currency of a country to be determined completely by the market forces is called floating exchange rate. However many countries do try to regulate the exchange rates of their currency and put some restriction on their free movement.
Countries may keep their currency rate stable by backing their currency by some standards item of value such as gold. For example for a long time the US$ was committed to redeem its currency at the rate of one ounce of Gold for 35$. However most of the countries have now abandoned the system of gold standards. Since 1970's most countries follow the floating rate system in which price of a currency rises or falls in relation to other countries is response to their demand in the international markets. However in practice, governments do intervene by selling or buying their own currency if there is steep rise or fall in exchange rates that is considered counter to the interest of the country.
Since the early 1970's, the major trading countries have had floating exchange rates. With such rates, the price of a nation's currency rises and falls in relation to world demand for that currency. This demand in turn is influenced heavily by the imports and exports of a country and the prices at which various goods are being sold and purchased by the country. Exchange rates of the currency of a country is likely to rise when id sell goods cheap in comparison to other countries and when its exports exceed its imports.
However, most governments intervene if the exchange rate for their currency rises or falls too far and take steps to prevent an excessive change. For this reason, the system is often called managed floating.
The exchange rate is basically how much you have to spend to buy another currency or how much you get when you sell your currency. This like anything else is dependent on the supply-demand graph.
People need to deal in currencies for two reasons, the first is to export or import goods and services to or from another country. The second is as a means of investment.
The first factor, influences the exchange rate based on how much a nation has to export or import from another nation. If the US import goods from China an importer in the US has to first buy the Chinese currency and then use that to buy goods in China. Similarly when the US exports goods to China, the importer in China buys the American currency and uses that to buy American goods. This movement of money decides how the exchange rate changes.
The second factor, influences the exchange rate based on how much more can your sending money to another country result in terms of increased returns to you. For example, if the interest rates that banks offer in the US is 2% and that in India is 8%, a person in the US would borrow money, at perhaps 2.5% from his bank in the US and invest it in India to get a net profit of 5.5%. To do this the investor first needs to buy the Indian currency and then deposit it in the Indian bank. Similarly, when the tenure of investment is over the Indian currency is used to buy dollars and bring the money back to the US. This again alters the exchange rate.