On February 3, 1690, the Massachusetts Bay Colony was said to have issued the first paper money in the U.S. in order to pay for military action against Canada during King William’s War.

Massachusetts was a truly pioneering colony when it came to money, as they were also the first to mint their own silver coins in 1652, despite a British law against it. The paper money created in 1690 was called a bill of credit, and represented the colony’s obligation to the soldiers. The soldiers could spend or trade the colony’s IOU just like silver and gold coins.

During the revolution of 1775, colonial leaders tried to replicate Massachusetts’ paper experiment on a wider scale, but the newly-christened continentals lacked any backing, such as silver or gold. On a small scale it may have worked, but so much money was printed that rapid inflation stripped them of all their value.

Less than 100 years later, two competing currencies were used to finance the opposing sides of the Civil War. Their values fluctuated with the fortunes of the war. Yet, it wasn’t until the National Banks Act after the civil war that the U.S. government introduced a monetary system where banks could issue paper notes based on their holding of government bonds. These disparate currencies were taxed out of existence in the following decades and replaced with national bank notes, giving the U.S. its first uniform paper currency.

To learn more about monetary policy, see “The Fed’s Tools for Influencing the Economy.”

• retail forex brokers
• central banks
• commercial businesses
• banks

In countries using a centralized banking model, interest rates are determined by their respective central banks.

In order to determine the interest rate, a government’s economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease). In the U.S., interest rates are determined by the Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.

For further background on the Federal Reserve’s functions, see our tutorial on The Federal Reserve.

Retail banks are typically the first financial institutions to expose money to the economy, and therefore they are the principal instruments used by the central bank to manipulate the money supply. Put simply, the central bank is able to regulate the supply of money to the end user (individuals and companies) by adjusting interest rates on the money it lends to or borrows from retail banks.

If the monetary policy makers wish to decrease the money supply, they will increase the interest rate, which makes it more attractive to deposit funds and reduce borrowing from the central bank. Conversely, if the central bank wishes to increase the money supply, they will decrease the interest rate, which makes it more attractive to borrow and spend money.

For further reading on interest rates, see “Interest Rates and Your Bond Investments,” “Forces Behind Interest Rates,” and “How Interest Rates Affect The Stock Market.”

The time value of money, or TVM, assumes a dollar in the present is worth more than a dollar in the future because of variables such as inflation and interest rates. Inflation is the general increase in prices, which means that the value of money depreciates over time as a result of that change in the general level of prices.

Changes in the price level are reflected in the interest rate. The interest rate is charged by financial institutions on loans (i.e., a mortgage or car loan) to individuals or businesses and TVM is taken into account in setting the rate.

TVM is also described as discounted cash flow (DCF). DCF is a technique used to determine the present value of a certain amount of money when received at a future date. The interest rate is used as the discounting factor, which can be found by using a present value (PV) table.

A PV table shows discount factors from time 0 (i.e., the current day) onward. The later money is received, the less value it holds, and $1 today is worth more than $1 received at a date in the future. At time 0, the discount factor is 1, and as time goes by, the discount factor decreases. A present value calculator is used to obtain the value of $1 or any other sum of money over different time periods.

For example, if an individual has $100 and leaves it in cash rather than investing it, the value of that $100 declines. However, if the money is deposited in a savings account, the bank pays interest, which depending on the rate could keep up with inflation. Therefore, it is best to deposit the money in a savings account or in an asset that appreciates in value over time. A PV calculator can be used to determine the amount of money required in relation to present versus future consumption.

To learn more about the basics of investing, see our Investing for Beginners crash course.

All currencies are traded in pairs. The first currency in the pair is called the base currency while the second is called the quote or “counterpart” currency. Usually the most dominant currency, in terms of the other currencies against which it trades, is quoted first. This is a matter of perspective because, from a local point of view, the local currency is the most dominant. One always wants to know just how much of the foreign currency one can get when exchanging the local currency. An American may want to know how many euros he can get for his dollar or, if he was traveling to Japan, how many yen he can get. (Interested in forex but don’t know where to start? Check out Top 7 Questions About Currency Trading Answered.)

However, based on international convention among banks, certain currencies have been assigned trading dominance. The euro represents some 17 countries that have joined the euro system and, therefore, has become the dominant base currency against all other global currencies, so it is quoted first. For example, the euro, represented as EUR, will be identified as EUR/USD, EUR/GBP, EUR/CHF, EUR/JPY, EUR/CAD, etc. All have the EUR acronym as the first currency in the sequence.

The British pound, originally the main currency of the world during the heights of the British Empire, is next in the hierarchy of currency name domination. The major currency pairs versus the GBP are identified as GBP/USD, GBP/CHF, GBP/JPY, GBP/CAD. Apart from the EUR/GBP, the GBP is usually the first currency quoted when it is involved in a currency pair. Because the U.S. dollar is the de facto world reserve currency since the end of the Second World War, and because commodity prices such as gold and oil are quoted in dollars, one could argue that the dollar is really the dominant currency of the world. In terms of convention, however, it ranks third in dominance and is quoted first against the Canadian dollar, Japanese yen and Swiss franc. In short, tradition and convention seem to play larger roles in the hierarchy of currency pairs than the relative economic strength of the economies that the currencies represent.(For further reading, see Using Currency Correlations To Your Advantage.)

The economic indicators used to forecast an exchange rate are the same ones used to determine the overall economic health of a country. The gross domestic product (GDP), consumer price index (CPI), producer price index (PPI), employment data and interest rates are all key determining factors of a country’s foreign exchange rates.

The CPI is another important indicator for investors and economists and is a metric for changes in price of a predetermined group of goods and services which are bought by households within a country. The CPI is used to track price changes and reflect inflation rates. A rise in prices on the CPI indicates a weakening in the purchase power of the country’s currency. Especially high inflation relative to inflation rates in other countries magnifies the effect of this factor.

The PPI measures the average change in sale price of all raw goods and services, and it examines these changes from the viewpoint of the producer and not the consumer. The PPI and CPI are obviously interrelated; increased producer costs are most often passed on to consumers.

Employment data is another indication of a country’s exchange rate. Higher employment rates are typically a sign of higher demand for production of the country’s goods, so it is therefore a signal that the value of a country’s currency is higher. Greater demand for products and services from a country results in an increase in the number of workers required to meet the demand. Higher demand usually means a country is doing more exporting, and more foreign currency is being exchanged in favor of the home country.

One final indicator widely used to forecast the exchange rate of a country is the interest rate set by its central bank. A country offering higher interest rates is usually more appealing to investors than a country offering relatively lower rates.

Point, tick and pip are terms used to describe price changes in the financial markets. While traders and analysts use all three terms in a similar manner, each is unique in the degree of change it signifies and how it is used in the markets. A point represents the smallest possible price change on the left side of a decimal point, while a tick represents the smallest possible price change on the right side of a decimal point. A pip, short for point in percentage, is similar to a tick in that it also represents the smallest change to the right of the decimal, but it is a crucial measurement tool in the forex market.

A point is the largest price change of the three measurements and only refers to changes on the left side of the decimal, while the other two include fractional changes on the right. The point is also the most generically used term among traders to describe price changes in their chosen markets. For example, an investor with shares in Company ABC stock might describe a price increase from $125 to $130 as a five point movement rather than a $5 movement.

Some indexes restate prices in a manner that allows investors to track price changes in points. For example, the investment grade index, or IG Index, tracks price movements to the fourth decimal. However, when quoting prices, it shifts the decimal four places to the left so movements can be stated in points. Therefore, a price of 1.23456 is stated as 12,345.6.

A tick denotes a market’s smallest possible price movement to the right of the decimal. Going back to the IG Index example, if this index elected not to shift the decimal place to use points, its price movements would be tracked in increments of 0.0001. A price change, then, from 1.2345 to 1.2346 would represent one tick. Ticks do not have to be measured in factors of 10. For example, a market might measure price movements in minimum increments of 0.25. For that market, a price change from 450.00 to 451.00 is four ticks, or one point.

A pip measures the price change in the currency market, with one pip equivalent to 0.0001. 

(To learn more about pips and their significance to forex markets, see “What Is a Pip?”)

During a trade deficit, the U.S. dollar generally weakens. Of course, there are numerous inputs that determine currency movements in addition to balance of payments, including economic growth, interest rates, inflation and government policies. A trade deficit is a negative headwind for the U.S. dollar, but it can still appreciate due to other factors.

A trade deficit means that the United States is buying more goods and services from abroad than it is selling abroad. Foreign firms end up with U.S. dollars. Typically, they use these U.S. dollars to purchase Treasury securities or other U.S.-based assets, particularly during periods of financial stability and growth.

If imports continue to exceed exports, the trade deficit continues to worsen leading to more outflows of U.S. dollars. The flow of dollars out of the country leads to weakness for the currency. As the dollar weakens, it makes imports more expensive and exports cheaper, leading to some moderation of the trade balance. As the currency continues to weaken, it makes U.S. dollar-denominated assets cheaper for foreigners.

The U.S. has run persistent trade deficits since the mid-1980s, but this has not translated into significant dollar weakness as would be expected. The primary reason is the U.S. dollar’s status as the world’s reserve currency. Dollar demand continues, as it plays a major role in global trade and reserves for central banks all around the world.

Major economies that issue their own currency, such as the European Union, Japan and England are in a similar space, where they can run persistent trade deficits. Countries that do not have the faith of the investing community are more prone to seeing their currencies depreciate due to trade deficits.