Currency - Supply –Demand –Inflation –Deflation - My Views

Currency – as we all know is a unit of purchasing power. Old days (Till 1971) we(government) used to back up the equivalent amount of gold for the existing currency floating in the market. Storing equivalent amount of gold always made sure that government can always redeem the gold in exchange to currency.
But this idea was not good..because the note (currency) had no face value (or trust to people) by itself , but it had value because of the back up gold present in reserves. This gave a lot of fluctuations in the economy ie., at times of war or crisis or unstable economy people used to feel that the government lost so much of gold (or money) and hence the currency they have doesn’t have a proper back up. Like for eg : Intially if Govt had 10 gms of Gold are there for 100 RS. After some economic problem, assume it had only 5 gms of gold. So as a result what happens. People realize that there is no enough backup and hence the trust (hence face value) of the currency decrease. In the above example the trust on the currency would have ideally fallen by half.
So in 1971 US Govt has decided to stop backing up any gold for currency. The immediate question everyone got was - what is the value of currency - with out any back up its just a paper..so is it not worth a pie ?. No – The Govt said – The value of the currency is the belief in the people that that particular paper has the worth . So that’s how currency has become just the belief of the people with out any true value behind it. Slowly all other countries followed US.

Some countries , taking this as an advantage , tried minting more currency in times of crisis or wars to pay of the debts they had to other countries.
What happened as a result, was a huge decrease in the face value of the currency.

Lets see how this happens –
If Supply of currency increases (ie., more minting of money) with limited supply of production of a country, the purchasing power of all people increases and hence everyone will be able to afford the supply of products...increasing demand..and so in an affect increases the cost of products.
Increase in cost of products is nothing but Inflation – This in other terms means the drop of the ability/facevalue/worth of the currency.

Question – When more currency is minted, but also supply of the products has also increased what will happen?
It tries to suppress inflation a lil bit..but if the production increases in parllel to supply of currency increase..there will be proper balance.(no inflation or deflation)
This is an ideal situation.

Question – So when is it appropriate for government to increase the currency supply(ie., mint currency)?

Ok. Lets say , The country’s GDP increases (ie., production/supply of goods increases) . Now there are more number of products in the market than before.
Infact people are willing to buy(ie., virtual demand) but they don’t have sufficient currency to buy the products. What happens because the demand (or virtual demand) is still high but the currency is not sufficient, the price of the product has to be decreased( to sell of the products). In other terms this means the face value of the currency increases , sometimes double fold , triple fold also. Although this situation appears better to us, it has equal –ve impacts on the country’s economy as Inflation. Ie., for example Exports will be affected because of deflation or FDI’s will decrease. So in these cases the Government might chose to mint more money to avoid a Deflation situation.

Now lets move one to the global scenario and see how does this have an impact on the Currency Exchange rate.

Lets assume in 2006 in US 1Kg of rice costed 1$ ( not real figures just an assumption) . The same 1 Kg of rice in India costed 20 Rs.
Now lets say by 2008 the production of rice in India increased with constant or a less equivalent raise in demand. Then the price of 1 Kg Rice decreases lets say to 10 Rs. But assume in USA in 2008 the production of Rice remained same (or less) and demand is same(or more). This means the price of 1 Kg of Rice ihas to be still 1$. Now just move to a little macro level by taking the production of rice to Overall production of the country.
The product that was purchased for 1$ in US is purchased in India in 25 Rs ( ie., ½ Dollar). Ie., the ratio of purchasing power of Dollar to Rupee was 1:2 in 2006.
In 2008 it became 1:4. ie., Rupee appreciated by twice over that period.

There are various other factors that determine an exchange rate. Trade value, inflation, and interest rates, to name a few. These are basic principles to help understand the concept.
Let's work in a closed vacuum and assume there is no inflation between two countries or any other factors and examine fluctuations based on wealth and trade. We begin with country A, which lets call the USA and country B which we call Britain. Lets imagine that 1 UD Dollar = 1 British Pound. Now let's say that the Americans own $100 and the British own 100 Pounds. If America buys $5 worth of product from Britain, America would have $95 and Britain would have 105 Pounds. Suddenly Britain becomes wealthier. In theory Britain is approximately 10% wealthier now. (100/95x105=10.52%) So suddenly $1 would be worth around 1 Pound and 10 Pence. This is the principle of trade surpluses and trade deficits and wealth within a currency.
Now let's imagine that America and Britain each have $100 again. Let's say that over 1 year, prices in America stayed the same but in Britain, prices went up 5%. We would now have an effect where Britain is 5% poorer then America and $1 would be now worth 1 Pound and 5 Pence. This is where interest rates are determined. Britain could have helped keep $1 worth 1 Pound by having an Interest rate of 5%.
Interest rates are determined normally by a Reserve Bank governor that determines economic policy for a currency. Interest rates can also be manipulated to stimulate an economy by strengthening or weakening a currency.
Now we can also consider what would happen if Britain deicide to print twice as much money as it had before. If America and Britain each has $100 and 100 Pounds each respectively, and Britain decided to print 200 Pounds in an attempt to get wealthier, suddenly $1 would equal 50 pence. However if Britain had found 100 Pounds of gold and was worth 200 Pounds, then $1 would still equal 1 Pound.
Very basically, this is how the system works, however is much more complex in reality
….will be continued…..soon…:-)