How Do Exchange Rates Work?

how do exchange rates work
A bank teller shows exchange rates. Photo: Derek E. Rothchild/Photodisc/Getty Images

Exchange rates tell you how much your currency is worth in a foreign currency. Think of it as the price being charged to purchase that currency. Foreign exchange traders decide the exchange rate for most currencies. They trade the currencies 24 hours a day, seven days a week. This market trades $5.3 trillion a day.

Prices change constantly for the currencies that Americans are most likely to use. They include Mexican pesos, Canadian dollars, European euros, British pounds and Japanese yen.

 These countries use flexible exchange rates. The government and central bank don't actively intervene to keep the exchange rate fixed. Their policies can influence rates over the long term. For more, see How Does the Government Regulate Exchange Rates?

You must plan for exchange rate values when you travel overseas. When the U.S. dollar is strong, you can buy more foreign currency and enjoy a more affordable trip. If the U.S. dollar is weak, your trip will cost more because you can't buy as much foreign currency. Since the exchange rate varies, you might find the cost of your trip has changed since you started planning it. For more, see ​How Do Exchange Rates Affect My Personal Finances?

You can Google the U.S. dollar to foreign currency exchange rate to get today's rate. It also shows a chart revealing whether the dollar is strengthening or weakening. If it's strengthening, you can wait until right before your trip to buy your currency.

Check to see if your credit card company charges conversion fees. If not, then using your credit card overseas will get you the cheapest exchange rate. If the dollar is weakening, you might want to buy the foreign currency now rather than waiting until you travel. Banks charge a higher exchange rate, but it might be cheaper than what you'll pay in the future.

Here are the recent changes in the Euro to Dollar Exchange Rate.

Other currencies, like the Saudi Arabian riyal, rarely change. That's because those countries use fixed exchange rates that only change when the government says so. These rates are usually pegged to the U.S. dollar. Their central banks have enough money in their foreign currency reserves to control how much their currency is worth.  To keep the exchange rate fixed, the central bank holds U.S. dollars. If the value of the local currency falls, the bank sells its dollars for local currency. That reduces the supply in the marketplace, boosting its currency's value. It also increases the supply of dollars, sending its value down. If demand for its currency rises, it does the opposite.

The Chinese yuan used to be a fixed currency. Now the government is slowly transitioning to a flexible exchange rate. That means it changes less frequently than a flexible exchange rate, but more frequently than a fixed exchange rate. For more, see Yuan to Dollar Conversion.

What Affects Exchange Rates?

The demand for a country's currency depends on what is happening in that country. First, the interest rate paid by a country's central bank is a big factor.

The higher interest rate makes that currency more valuable. Investors will exchange their currency for the higher-paying one. They then save it in that country's bank to receive the higher interest rate.

Second, is the money supply that's created by the country's central bank. If the government prints too much currency, then there's too much of it chasing too few goods. Currency holders will bid up the prices of goods and services. That creates inflation.  If way too much money is printed, it causes hyperinflation. That usually only happens when a country must pay off war debts, See more about the Types of Inflation.

Some cash holders will invest overseas, where there isn't inflation. But they'll find that there isn't as much demand for their currency since there's so much of it. That's why inflation will push the value of a currency down.

 

Third, a country's economic growth and financial stability impact its exchange rates. If the country has a strong, growing economy, then investors will buy its goods and services. They'll need more of its currency to do so. If the financial stability looks bad, they will be less willing to invest in that country. They want to be sure they will get paid back if they hold government bonds in that currency.