For example, the British pound sterling may trade for more U.S. dollars today than it did yesterday. This does not necessarily mean, however, that the U.S. dollar is absolutely worth less than the day before in terms of real purchasing power. In either case, the economic roots of currency depreciation are dependent on the productive capacity of an economy and the size of its money supply.
Almost every major currency is controlled like a monopoly through legal tender laws. For this reason, governments and central banks control the factors that influence currency value. Even though these are not traditionally considered to be economic factors, they are nonetheless critical determinants.
Productivity and Absolute Currency Value
Money exists as a store of value. Employees trade the value of their working labor for a representative amount of money (in wages) and then trade that representative value for other goods and services in the market.
As an individual employee creates more value through increased productivity, she will see her salary increase proportionately. Her employer (or customers) must either give her more units of currency or more valuable units of currency.
If the money supply in a country is fixed but productivity increases, then each unit of currency must store greater value. If the productivity of an economy is fixed but the supply of currency decreases, then each unit of remaining currency must store greater value.
The opposite is also true. When productivity declines faster than the supply of money, the value of each unit of currency drops. The most common monetary phenomenon, inflation, is produced the other way around – the supply of money grows faster than productivity. There are more units of currency around to absorb productivity, so each one ends up representing less exchange value in the market.
Purchasing Power vs. Forex Value
The foreign exchange markets are particularly complex. This is partly because there are two types of forex traders. The first type of trader is looking to make a purchase in a foreign market, so he needs to convert one currency to another. The vast majority of these transactions are performed by banks or other major financial institutions on behalf of their domestic customers.
The second type of trader is simply looking to trade currency with a lower expected future value for currencies with higher expected future values. This currency speculation plays an important function in international markets, but it is forward-looking and doesn't cleanly equate to current purchasing power or national productivity.
The wide range of possible factors that influence currency value in international markets includes the relative monetary policy between governments and central banks, differences in economic forecasts between one country and another, the differences in productivity between one set of workers and another, and the relative demand for the goods and services produced between different countries.