Answer by Balaji Viswanathan:
Bothand have done a great job to explain this already. I will try to add a little bit.
What is a trade?
The fundamental beauty of nature lies in the art of trade. Here you see a crocodile that keeps its mouth open so that tiny birds could come & eat particles stuck between its teeth. The crocodile gets its mouth clean while the birds gets their food. Win-Win. This is the foundation of capitalism & the central part of is this thing called the trade – the crocodile gives up the food in its mouth in return for a healthier teeth.
If even an "ugly" croc could see the benefit, why can't we . Of course, it didn't take humans long in discovering this "symbiotic relationship". Since one man cannot produce everything, humans discovered a system of trade. People exchanged stuff they produced with others and this gave them a lot of benefit.
For instance, a rice farmer would take a part of his rice & take to the milk man, oil farmer and a wood farmer. In return for giving a part of his rice, he gets milk, firewood and oil to have a more healthy life. If all he had was rice, life would be pretty tough.
How trade works?
Before we had currencies, we had a barter system. People would decide among themselves how many cans of milk equal a sack of rice. This primarily depended on how hard it is to produce milk & rice, as well as how much supply is there. If there is a lot of milk, then the milk man would be willing to give a lot of it in return for getting his share of rice.
After a while the farmer, milkman and others work to bring up a table with conversion. For instance, one kilogram of rice could get 10 liters of milk or 5 liters of oil or 7 kilograms of firewood.
You can see that the conversion is pretty random & often changes. Sometimes oil gets more valuable during festival seasons while rice gets more valuable during the non-harvest times.
This is exactly how Forex market works. Dollar, Rupee, Pound, Yen are just like Rice, Milk, Oil and Wood in the above table. They can all be converted to each other & decided among the various people exchanging/trading the stuff.
What the conversion indicates?
1 kg of rice can buy 10 liters of milk.
Does that mean that milk is less tasty than rice? No.
Does that mean the milk man is less smart than a farmer? No.
Does that mean it is pointless to make milk? No.
All it means is that it is easier to produce milk and thus there is a lot of it. If the supply of milk goes down a lot, then the milk value will go up. But, it doesn't mean the farmer is happy [he has a lot less milk to sell now]. In the same way, when India gets into deflation there will be a lot less currency and rupee's value against other currencies will move up. But, that doesn't mean India is happy.
In the same way, when milk production is rapidly increased there will be a lot of excess milk & the price of milk will come down. This is called inflation. The farmer is not happy even in this case – as he has excess supply & he has destroyed his market value.