How Do Exchange Rates Work? [Explanation & Examples]

Wondering how do exchange rates work?

I’ve you’ve even travelled from one country to another that uses a different currency you have probably exchanged your dollars for pounds, or your dollars to pesos, or maybe your yen to GBP.

If so, you have seen exchange rates in action. But, how well do you understand how they work?

Have you ever heard financial reporters mention stuff like the dollar fell against the euro and wondered what they meant?

Well, today, we’ll explain what this means and even let you know some of the factors that affect the value of currencies around the world.

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How Does Exchange Rates Work? A Detailed Look

Exchange rates determine the worth of a given currency. It can be equated to the price of purchasing that given currency. Foreign exchange traders set the exchange rate of almost all currencies. Currencies are traded on 24/7.

The price of currencies is constantly changing and governments or the central bank is not actively involved in keeping the exchange rates fixed. However, the policies they set can influence the rates in the long term but does not regulate them.

When travelling overseas, it is important that you have exchange rates in mind.

If the U.S dollar happens to be strong, you are able to buy more foreign currency hence your trip becomes affordable.

On another hand, if the U’S dollar is weak, you trip could end up being more expensive than you had thought because you can’t buy as much foreign currency.

The varying exchange rates will affect the cost of your trip either in a positive or negative way.

This is how exchange rates affect your personal finances.

A simple Google search reveals whether the dollar is weakening or strengthening.

If it’s strengthening, then the perfect time to buy your foreign currency will be just before your trip.

If it’s weakening, you may want to buy your currencies now rather than wait till just before your trip.

Banks may charge a higher exchange rate, but these rates may end up being cheaper than what it could cost you in future.

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Countries such a the Saudi Arabian riyal have a rarely changing exchange rate because it’s only the government that can instruct on the changes.

Their rates are pegged on the U.S dollar as their banks have more than enough foreign currency reserves hence they can control how much their county’s currency is worth.

In order to maintain a fixed exchange rate, their central bank golds money in the U.S dollar. Should the local currency’s value fall, the bank buys it.

This causes a reduction in the amounts circulating hence increasing the local currency’s value. The number of dollars in circulation increase, decreasing its value.

Some time back, the Chinese yuan was a fixed currency. However as the days go by, the government is gradually embracing the flexible exchange rates.

Factors Affecting Exchange Rates

Interest Rate

The demand for a county’s currency is affected by what that given country is experiencing at a given time.

One of the biggest factors is the interest rates paid by that county’s central bank.

If the interest paid is high, the value of that county’s currency is higher.

Investors will go for the high paying currency in exchange for the low paying one.

The money they have acquired is then saved in that country’s bank so that they can also enjoy the high-interest rates.

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Money Supply

If a country happens to have too much money in circulation due to it being printed in huge sums, a large amount of money will be chasing goods that are too few.

Inflation will be created as a result of currency holders bidding up the prices of goods.

Hyperinflation is caused if too much money is printed. It is the most extreme form of inflation that tends to happen when a country is trying to pay off war debts. Or it could be caused by corruption in the government as seen in Venezuela.

Most of the cash holders will end up investing in overseas countries that are not experiencing any form of inflation.

However, they will realize that there’s so much of their currency’s demand that not so much of it is needed anyway.

As a result, the country that’s undergoing inflation ends up with a currency whose value is low.

Economic Growth

A county with a strong, financial stable economy that’s on a growing trajectory will have many investors interested in its goods and services.

For them to trade for the goods and services, they will need the country’s currency.

They need the assurance that should they hold government bonds in that country’s currency, then they will be paid when that time comes.

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The Euro

In 2002, the Euro became the second-largest currency in the world after the US dollar.

This saw it replacing sixteen natural currencies over the years. Even though it has been used to enhance political solidarity, the unifying effect has been felt by the participating countries. Some of the effects include:

Elimination of fluctuating exchange rates across particular borders

Significant reduction in transaction costs as tourists no longer needed to exchange their money as they crossed from one border to the other.

Increased trades across the Euroland countries due to the elimination of exchange-transaction costs and increased transparency.

Increased employment across the borders as people could no cross the borders and still earn in the same currency as their home countries.

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