How Do Currency Exchange Rates Work?
There are 2 types and 3 factors that affect them
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. For example, in April 2020, 1 euro was equal to $1.2335 U.S. dollars, and $1 U.S. dollar was equal to 0.81 euros. Foreign exchange traders decide the exchange rate for most currencies. They trade the currencies 24 hours a day, seven days a week. As of 2019, this market trades $6.6 trillion a day.
- An exchange rate is how much of your country's currency buys another foreign currency.
- For some countries, exchange rates constantly change, while others use a fixed exchange rate.
- The economic and social outlook of a country will influence its currency exchange rate compared to other countries.
2 Kinds of Exchange Rates
There are two kinds of exchange rates: flexible and fixed. Flexible exchange rates change constantly, while fixed exchange rates rarely change.
Most currency exchange rates are determined by the foreign exchange market, or forex. Such rates are called flexible exchange rates. For this reason, exchange rates fluctuate on a moment-by-moment basis.
Prices change constantly for the currencies that Americans are most likely to use. These 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, but for most countries, the government can only influence, not regulate, exchange rates.
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 Chinese 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. As of January 21, 2021, $1 U.S. dollar was worth about 6.4800 Chinese yuan. Since February 2003, the U.S. dollar has weakened against the yuan. One U.S. dollar could be exchanged for 8.28 yuan at that time. The U.S. dollar has weakened because it can buy fewer yuan today than it could in 2003.
Why the Euro Is So Special
Most exchange rates are given in terms of how much a dollar is worth in the foreign currency. The euro is different. It's given in terms of how much a euro is worth in dollars. It is hardly ever given the other way around. So, although $1 U.S. dollar was worth 0.85 euros in October 2020, you would only hear that 1 euro was worth $1.1706.
The euro has weakened considerably since April 2008. At that time the euro was at its all-time high of $1.60. Since then, the future of the European Union and the euro itself was in doubt after the United Kingdom voted to leave the European Union. In addition, the European Central Bank (ECB) had been lowering its interest rate. This reduced bank rates for anyone lending or saving in euros. That reduced the value of the currency itself.
Yet, the euro is special. It's the second most popular currency after the dollar. More than 341 million people use it as their sole currency. The euro's popularity derives from the power of the European Union. It's one of the largest economies in the world.
Three Factors Affecting Exchange Rates
Interest rates, money supply, and financial stability all affect currency exchange rates. Because of these factors, 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.
Hyperinflation usually only happens when a country must pay off war debts. It's the most extreme type 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 can push the value of a currency down.
Third, a country's economic growth and financial stability impact its currency 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.
How Exchange Rates Affect You
If you're traveling overseas to another country that uses a different currency, you must plan for exchange rate values. 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. This is just one of the ways exchange rates affect your personal finances.
You can search online to find the exchange rate of the U.S. dollar to foreign currency for any given day. Google has a tool to help with this. It even 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.