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I would like to understand in atomic terms what makes the value of one nation's currency change with regard to another. Read that, without citing complex terminology but in basic terms.

Obviously, if one nation does QE then it would follow that the value of that currency is devalued by the ratio of "easing" to the existing supply.

But in all other cases, suppose you have nation A and nation B and their currencies are initially 1-to-1. What would make nation A's currency be worth more than nation B's currency, and what is the rationale behind it?

So for example, nation A becomes more efficient in manufacturing than nation B; but how would that make the currency of nation A worth more? Efficiency is the only answer that comes to mind, so I appreciate further elaboration and hope this question has educational value.

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Exchange rates are prices. Just like any other price, they change based on supply and demand. Country A's currency appreciates relative to B if the citizens of country B want county A's currency. Why does B want A's currency? Typically for the purpose of buying the goods, services, and investments produced by A.

So what would be some examples of events that would cause A's currency to appreciate relative to B?

  1. If A starts producing some goods B wants, or producing them efficiently, then B will want A's currency in order to buy them
  2. If A has desirable investments (savings accounts, financial assets, or real assets) and B wants a place to save for the future
  3. If A expands their money supply more slowly than B, which reduces the available supply of A's currency relative to B's.
  4. If A's currency is useful for some other purpose, like acting as a medium of exchange between B and another country C.
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  • $\begingroup$ Great answer, will be helpful to someone I hope. If you have time, a footnote on HOW a nation expands their money supply for example QE 2 in the US would be helpful. Also, so why for example has the Russian Ruble fall so far against the dollar? $\endgroup$ – Oliver Williams Mar 31 '17 at 8:32
  • $\begingroup$ The common mechanism by which the money supply expands is the central bank making new money and using it to buy stuff. During QE2 the Fed bought a ton of bonds, bank debt, and other securities. Where did it get the money for this? It made it up. So that was brand new money injected into the system. When these securities mature, money flows again to the Fed, which reduces the money supply, so the Fed has to keep buying more to maintain that level. Interest on Fed reserves and Fed-owned securities that default will permanently expand the money supply. $\endgroup$ – farnsy Mar 31 '17 at 19:01
  • $\begingroup$ To be clear, inflation and expansion of the money supply are not the same thing. Inflation means rising prices (reduced value of local currency) which can be cause by many things on the supply or demand side. In Russia's case, probably all of my above examples apply to why the dollar (A) appreciated relative to the Ruble (B). $\endgroup$ – farnsy Mar 31 '17 at 19:02

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