Let us try to understand the vicious circle US and China are into currently and how the whole world is at a risk of a major upheaval in the near future. This topic will involve many jargons from the finance world and I will explain them as and when they appear.
The Background - Understanding how currency rates fluctuate daily (Know it? Skip it)
The number of factors that determine the currency rate is large and they vary from macro-economic factors like interest rate, fiscal deficit, overall debt of the nation etc to day to day factors like demand and supply. As a thumb rule, if there is a greater demand for a particular currency as compared to other, given limited supply, that currency appreciates versus other currencies and vice-versa. This is assuming the market is free from any regulatory restriction on currency rate. Examples of free flow/market based currencies are US Dollar, Euro, Japanese Yen etc.
However, there are other kinds of currencies which have government/central bank as a regulator who restrict free fluctuation of the currency. This is done for various reasons like protecting export industries for example. Such currencies are pegged (fixed) against some reference currency or a basket of currencies and the fx rate is not allowed to fluctuate or limited (capped and floored) fluctuation is allowed. To maintain this constant rate, the central bank has to play an active role to buy/sell foreign currency and maintain the peg. Example of restricted currency is Chinese Yuan.It was pegged against the US$ and slow liberalization was allowed in the last decade due to international pressure. As uneven trade between two countries follows, it creates surplus for one currency and shortage for the other. At such times, restricted currency regimes need to intervene and ensure that the fx rate is at the pegged rate by buying/selling the currencies.
This video from khanacademy.com is an excellent starting point.
