We all hear about how a country’s currency “is weaker than it was” or “stronger than ever,” but what do those terms really mean? After all, a dollar is a dollar, a Euro is a Euro, etc. However, you could have the exact same amount of money during a recession as you do during a peak in the economy, but that same amount would have different “strengths” depending on the overall economy. Let’s take a look at what currency strength means, and how it applies to your life in both day-to-day and the big picture.
Understanding Purchasing Power
To break it down into its simplest example, let’s say you have one unit of currency. In this case, we’ll use the US Dollar. If you walk into a store with exactly $1 and there’s a pack of bubble gum that you want to buy, the price of that gum will determine your purchasing power. If the gum is marked as being $0.50 (half a dollar), then you can purchase two of them. This makes the dollar very strong in the economy since you can buy more with what you have.
On the other hand, the gum may be marked at $1.25, meaning that you can’t buy any of it. This is what’s known as purchasing power, and a strong currency means that it has a higher purchasing power. Purchasing power is commonly measured by the Consumer Price Index (CPI) so that people can see, in real-time, the purchasing power of the money that they have.
Inflation’s Role in Currency Strength
With inflation, prices of products can increase dramatically and in an instant. There have been many cases in which a currency’s strength has been demoralized by inflation around the world. It happened to Germany’s economy following World War I, Hungary after World War II, and in more modern times with Yugoslavia and Venezuela.
Most developed countries don’t have to face an inflation rate that crashes the economy, but it does happen from time to time. Many will remember the global recession in the mid-to-late 2000s that made housing prices next to nothing. Since the amounts of currency don’t change, that means that a single unit can lose or gain value depending on inflation. If inflation stagnates and wages exceed the inflation rate, then the currency’s strength and purchasing power will rise.
International Trade Impact
Just because one unit of currency may be able to purchase a lot in your home country doesn’t make that particular currency strong on a global scale. If a currency’s strength on an international scale isn’t high, then it won’t be accepted in international trade.
The Reserve plays a big part in currency strength, and there have been instances of weaker currencies losing their high rating with Standard & Poor. Countries like Japan, the United States, Great Britain, etc., do a lot of currency trade, so it’s important for these companies to keep their currency strong.
Speaking of Standard & Poor, each country is given a credit rating based on its currency’s strength and ability to pay back money borrowed from other countries. The highest grade given out by S&P is an AAA score, running down to a BBB level for currencies that are still likely to be invested in.
Anything below that, though, is a speculative non-investment grade. This ranges from BB to D. D is the lowest rating (besides NR for Not Rated), which means that the country has defaulted several times, has a low currency strength, and can’t be trusted for future loans.
To sum it up, having a strong currency is vital for any country’s economy. This is why you’ll often hear politicians talking about needing a strong dollar, yen, pound, etc. If they aren’t strong, it can lead to a nationwide recession that leaves millions scrambling for options on a day-to-day basis.