Exchange Rates Explained

The Two Types of Exchange Rates

exchange rate
••• Photo by Jeff J Mitchell/Getty Images

Exchange rates are the amount of one currency you can exchange for another. For example, the dollar's exchange rate tells you how much a dollar is worth in a foreign currency. For example, if you traveled to the United Kingdom on January 29, 2019, you would only receive 0.77 pounds for your one U.S. dollar. You would get a little less than the exchange rate as the banks charge their service fee. Conversely, a pound was worth $1.31.  

Flexible Exchange Rates

Most 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.

Flexible rates follow what forex traders think the currency is worth. Those judgments depend on a lot of factors. The three most important are the central bank’s interest rates, the country's debt levels, and the strength of its economy. 

The United States allows its forex market to determine the U.S. dollar's value. The U.S. dollar strengthened against most currencies during the 2008 financial crisis. When stock markets fell worldwide, traders flocked to the relative safety of the dollar. But, why was the dollar safe? After all, the crisis started in the United States. The dollar becomes strong when either demand for it surges or the value of the euro falls.

Despite this, most investors trusted that the U.S. Treasury would guarantee the safety of the world's global currency. The dollar took on that role when it replaced the gold standard during the 1944 Bretton Woods agreement. That's the underlying reason for the power of the U.S. dollar

The following chart visualizes the relationship between the Euro, the U.S. Dollar, and the flexible exchange rate they both rely on.

Fixed Exchange Rates

When a country's currency doesn't vary according to the forex market, it has a fixed exchange rate. The country makes sure that its value against the dollar, or other important currencies, remain the same. It buys and sells large quantities of its currency, and the other currency, to maintain that fixed value.

For example, China maintains a fixed rate. It pegs its currency, the yuan, to a targeted value against the dollar. As of January 29, 2019, one dollar was worth 6.73 Chinese yuan. Since February 7, 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.

The U.S. government pressured the Chinese government to let the yuan rise in value. This allows U.S. exports to be more competitively priced in China. It also makes Chinese exports to the United States more expensive. The U.S.-China trade deficit shows a huge imbalance favoring China. The United States spends more buying Chinese goods than it makes selling American-made products to China. As a result, China’s volume of exports to the United States largely outweighs its American imports.

On August 11, 2015, China modified its policy to allow the yuan more flexibility. China wants to reduce its reliance on the dollar. It also wants the yuan to be more widely traded. The yuan to dollar conversion is one of the most widely monitored exchange rates. These currencies are backed by the two of the largest economies in the world.

The following chart visualizes the difference between a fixed exchange rate, and an exchange rate that was once fixed and then became flexible.

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 one U.S. dollar was worth 0.87 euros on January 29, 2019, you would only hear that one euro was worth $1.14. In that way, it is similar to the British pound.

The euro has weakened considerably since April 22, 2008. At that time the euro was at its all-time high of $1.60. That's because 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 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.

The ECB announced its version of quantitative easing in March 2015. That dropped the euro's value to $1.10. The euro also weakened during the Greek debt crisis. The history behind the euro to dollar conversion relates a timeline of its declining strength against the U.S. dollar. 

Yet, the euro is special. It's the second most popular currency after the dollar. More than 332 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 three largest economies in the world. Even though the euro hasn't been adopted by all EU countries, no other currency comes close to being a global currency

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