What Are Exchange Rates?

exchange rate
A man walks past a Bureau De Change on November 27, 2014 in Edinburgh, Scotland. Lord Smith, announced that the Scottish Parliament should have the power to set income tax rates and bands, he also said that a share of VAT should be distributed to parliament and air passenger duty fully devolved. (. Photo by Jeff J Mitchell/Getty Images

Definition: Exchange rates allow you to determine how much 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, and vice versa. You will definitely need to understand exchange rates when you travel to another country. For example, if you traveled to the United Kingdom on June 24, 2016, you'd find a dollar was worth $1.32 British pounds.

That means you could hand over a $1 bill and get $1.32 in English currencies. (You'd get a little less than the exchange rate since banks charge a fee.)

Flexible Exchange Rates

Most exchange rates are determined by the foreign exchange market, known as forex. For this reason, exchange rates vary on a moment-by-moment basis, depending on what forex traders think the currency is worth. This depends on a lot of factors, including central bank interest rates, the country's debt levels, and the strength of its economy. Most countries allow their currencies to be determined by the forex market. This is known as a flexible exchange rate.

The United States allows the forex market to determine its value. The dollar strengthened against most currencies during the 2008 financial crisis. For example, the dollar was worth $2.06 British pounds. As stock markets around the world fell, traders flocked to the relative safety of the dollar.

Why was the dollar safe? After all, the crisis started in the United States. It continued to worsen until March 2009. Despite this, most investors trusted that the U.S. Treasury would guarantee the safety of the world's global currency. That's because the dollar replaced the gold standard, thanks to the 1944 Bretton Woods agreement.

 For more on the dollar's role, see Value of the U.S. Dollar, the Power of the U.S. Dollar, and Why Is the Dollar So Strong Right Now?

Fixed Exchange Rates

One country that has traditionally had a fixed exchange rate is China. It pegs its currency, the yuan, to a fixed value against the dollar. As of June 7, 2016, one dollar was worth 6.57 Chinese yuan. The dollar has weakened against the yuan since February 7, 2003, when a dollar could be exchanged for 8.28 yuan.

China has to manually adjust the exchange rate of the yuan to the dollar. That's because 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 U.S. more expensive. For more on how this affects you, see U.S. China Trade Deficit.

However, on August 11, 2015, China modified its policy to allow the yuan more flexibility. For more, see Yuan to Dollar Conversion.

Why the Euro Is 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 typically given in terms of how much a euro is worth in dollars. It's hardly ever given the other way around.

So, although the dollar was worth 0.89 euros on June 26, 2016, you would only hear that one euro was worth $1.11.

The euro has weakened considerably since its all-time high of $1.60 on April 22, 2008. That's because the future of the European Union and the euro itself was in doubt after Great Britain voted to leave the European Union. In addition, the European Central Bank (ECB) had been lowering its interest rate. This lowered bank rates for anyone lending or saving in euros, also reducing the value of the currency itself. When the ECB announced its version of Quantitative Easing, the euro's value plummeted to $1.10 in March 2015. The euro also weakened during the Greek debt crisis.For more on the history of exchange rates between the dollar and the euro, see Euro to Dollar Conversion. (Source: Federal Reserve Bank of New York web site)

Nevertheless, the euro is special is because it is the second most popular currency after the dollar. It is used by 332 million people as their sole currency. The euro's popularity derives from the power of the European Union, which runs neck and neck with the U.S. on being the largest economy 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

Exchange Rates FAQ