Finding the products that your country should produce is the first task, selling them on the international market is the next. This would be easy if every nation used the same currency—but they don’t. So before goods can be exchanged the parties to the transaction have to agree on what currency to use. Generally, this means that the buyer must get ahold of some currency from the seller’s country so he can buy the good.
If a Briton buys bread in Bristol, how does he pay for it? Easy, he uses his local currency—British pounds sterling. But what if he wants to buy a monkey from Madagascar? (Well, first he may have some problems with his friendly local customs and animal control agents, who usually don't like it when people try to import rare tropical monkeys. But let's not worry about that for the moment...) Assuming it's cool for our British friend to import a monkey, he'll need to figure out how to lay his hands on some Malagasy ariarys—yup, that's the official currency of Madagascar, but of course you already knew that—to pay his monkey dealer.
How does he get Malagasy ariarys? He buys them, using his British pounds. But how much do they cost? How many pounds is an ariary worth?
That depends on supply and demand. How many people around the world want to get their hands on an ariary today? If lots of people want to hold ariarys but there aren't many to go around, their value will increase and it will cost our British friend more pounds to buy them. But if nobody really wants ariarys and the Madagascar government is printing them like there's no tomorrow, they won't hold much value against the pound. (As of June 2010, one pound was worth almost 3300 ariarys... just in case you were curious.)
Why It Matters Today
What does supply and demand in the currency markets mean to you? Ever thought about traveling to Europe? Or buying a European-made car, or wristwatch, or chocolate bar?
All of those things might be getting cheaper soon. Why? Because a series of financial crises have rocked the continent in the last few years, hammering economies from Iceland to Spain to Greece. Since most European nations share the same currency, the euro, a collapse in confidence in, say, Greece, may lead currency traders to lose confidence in the euro itself. Loss of confidence equals drop in demand, which equals drop in value... and voila, your can suddenly buy euros for fewer dollars or yen or pounds sterling.
Sometimes, a Song Says it Better: Euros and Pounds, by Pretty Balanced
A currency trader at heart, she has euros, pounds, shillings, and cents.