If you are planning to visit another country or want to send money to someone abroad, you may know a little bit about currency exchange rates.
But, on a deeper level, what are exchange rates? How do they work?
In this article, we’ll explore the ins and outs of exchange rates. We’ll cover everything from the basic terminology to interest rates’ role in determining exchange rates.
What is an exchange rate?
An exchange rate is the going rate you’d pay to trade your currency for another. For example, if you needed to exchange 100 US dollars (USD) for Canadian dollars (CAD), you’d check the exchange rate to see how many Canadian dollars you’d receive in return. So, if the exchange rate were 1 USD – 1.3426 CAD, you’d get 134.30 CAD back.
Exchange rates go up or down due to changes in market conditions, a country’s economy, or government policies. Depending on where you exchange money, you might also pay fees for the transaction.
So, what’s the deal with those three-letter codes for US and Canadian dollars? Well, because currencies have different names in different languages, each has a three-letter code that represents it internationally.
The International Organization for Standardization (ISO) sets these codes to offer a consistent way to identify currencies in foreign exchange (forex) trading. For example, if you wanted to exchange USD and British pounds (GBP), the exchange rate would display as USD – GBP, just like our USD – CAD example.
How exchange rates work
How do exchange rates work? Why are different currencies worth different amounts? And why do they constantly fluctuate?
There’s no simple answer, as the forces that set and move exchange rates happen on a global stage. International trading, monetary policy decisions, investor expectations, the political climate, and the overall economic conditions all have their say in determining exchange rates.
Whether a government uses a fixed or floating exchange rate system plays a major role. So do supply and demand on the foreign exchange market, inflation, and interest rates.
Let’s look at each factor, starting with how floating and fixed exchange rates work.
Floating vs. fixed exchange rates
While most countries’ exchange rate will move up or down over time, some don’t. This is because there are two types of currency exchange rates: floating and fixed.
Most countries have floating exchange rates, which means the buying and selling on foreign exchange markets determines the value of their currency.
In a fixed exchange rate system, a country’s government or central bank uses monetary policy to maintain currency values within a set range. They’ll often do this by tying rates to the value of a foreign currency or basket of currencies.
For example, the Saudi riyal (SAR) is “pegged” to the US dollar. As the value of the US dollar changes, the Saudi government buys and sells its currency or adjusts its interest rates to keep the USD – SAR exchange rate fixed at around 3.75.
Supply and demand
Currency values move constantly because they’re traded around the clock. And that’s why supply and demand forces so strongly affect exchange rates.
- Supply is the total amount of a currency that is available to buy.
- Demand refers to how much interest there is among investors, businesses, and the public in buying that currency.
If demand is greater than supply, the price of a currency will go up. If demand is less than supply, the price will go down.
A country’s economic health, growth prospects, and monetary policies affect the supply and demand for its currency. A lot of people from outside a country’s borders investing in local companies or buying goods produced in that country creates more demand. This can put upward pressure on the value of its currency.
Inflation
Inflation, the rate at which goods and services increase in cost over time, can drive interest rates up or down.
Higher inflation tends to weaken a currency’s exchange rate. That’s because it decreases the purchasing power of that currency.
Lower inflation generally pushes a country’s currency exchange rate upward. It means more buying power, more investor confidence, and thus more demand for that currency.
Interest rates
Interest rates—the percentage of a loan amount a lender charges for loaning a borrower money—also influence exchange rates.
A country’s central bank sets its benchmark interest rate, which determines borrowing costs for businesses and individuals. This affects how attractive it is to hold that currency for investment purposes.
Lower interest rates boost the economy by making it cheaper for businesses to invest and grow. However, keeping rates too low for too long can lead to high inflation. Because a country’s currency can buy fewer goods and services over time during periods of high inflation, it loses value not only in relation to other currencies but also inside its borders.
Most countries have at least a bit of inflation every year, though central banks will usually try to keep inflation below a certain limit, often around 2%.
If inflation gets too high, central banks will raise interest rates to fight it. A little bit of inflation is often seen as safer for the economy than deflation, where money is worth more and more every year because prices decrease. When deflation happens, people and businesses tend to save money instead of spending and investing it, shrinking the economy.
Why exchange rates are important
At the highest level, exchange rates are important because they’re an indicator of a country’s financial health. A currency’s value usually rises when its country’s economy is strong and falls when the economy weakens. So, basically, exchange rates can be a good gauge of economic standing.
Why else should you keep an eye on a country’s exchange rate? Well, a few reasons. Exchange rates are also important to:
- International trade: Exchange rates affect the cost of importing goods and the prices businesses get for exporting products. Thus, exchange rates directly impact profit margins and a country’s competitiveness in international trade. While a strong currency can make imports cheaper, it isn’t always beneficial for exports. For example, a weak currency makes it cheaper for businesses and people abroad to buy a country’s goods. This can grow your country’s economy and tax revenue.
- Foreign investment: Investors look at things like exchange rates, political stability, and economic growth to inform their decision-making. A strong currency can attract more foreign investment.
Travel and tourism: Exchange rates determine a currency’s purchasing power abroad—and other currencies’ purchasing power within your borders. Because travelers need to exchange their currency for their destination’s local currency, this has a huge impact on tourism. A weaker currency might attract tourism to your country because it offers travelers more purchasing power. Conversely, a strong currency might mean your money will go further if you travel to another country. But it also might make domestic travel more expensive.
Bid vs. ask price
If you’ve ever tried to exchange two currencies, you may have noticed that the price to sell a currency and the price to buy it are not the same. This difference between buy and sell prices for a currency is called a spread. It’s how foreign exchange dealers make money.
When you want to buy a currency, a dealer will give you their “ask price.” This will be higher than the dealer’s “bid price” (what they are willing to pay to buy that currency back). Different dealers may set their prices differently, so looking around for the best rate is a good idea.
For example, if you’re traveling and exchange money at an airport, you’ll probably get a worse deal than finding a currency exchange shop in town. Often, the smaller the difference between the bid and ask prices, the better the rate you get.
Exchange rate example
Here’s an example of how foreign exchange rates work and how to calculate them. Say you’re a US resident traveling to London and need to exchange your USD for GBP.
You visit a foreign exchange shop in London and see that the prices for currency conversion between USD and GBP are:
- Buy USD:2911
- Sell USD:2641
Since the shop is in London, the prices for USD are in relation to 1 GBP. If you have 1,000 USD you want to convert to GBP, the calculation will be:
1,000 USD / 1.2911 = 774.53 GBP\
If, at the end of your trip, you have 100 pounds left and you want to convert them back into dollars at the same shop, you would receive:
100 GBP * 1.2641 = 126.41 USD
Of course, if your trip was a few days long, the currency exchange rate may have shifted up or down, so you might get less or more money back.
FAQs
How does the exchange rate system work?
In a floating exchange rate system, exchange rates are set on the international foreign exchange (forex) market, where currencies are bought and sold among banks, businesses, individuals, and governments. The price of a currency is set by supply and demand.
In a fixed exchange rate regime, governments and central banks intervene to keep exchange rates within a set range. They usually do this by “pegging” their currency exchange rates to the value of a foreign currency or basket of currencies.
Which currency has the highest value?
The currency with the highest value in the world is the Kuwaiti dinar (KWD), which has an exchange rate of around 3.25 US dollars per 1 dinar. Kuwait’s managed exchange rate system keeps the dinar’s value high by “pegging” it to an undisclosed basket of other currencies. This helps Kuwait keep the dinar’s value stable.
What makes a currency weak?
A currency is weaker than another currency if it is worth less on the foreign exchange market. Currencies can weaken due to a variety of different factors, including inflation, recessions, bad monetary policies, and political instability. The strength of a country’s currency is often viewed as an indication of its economic health.
