Exchange Rates Explained
The Two Types of Exchange Rates
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 instance, if you traveled to the United Kingdom on June 19, 2017, 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 $1.29.
Flexible Exchange Rates
Most exchange rates are determined by the foreign exchange market, or forex. That's called a flexible exchange rate. For this reason, exchange rates fluctuate on a moment-by-moment basis.
The flexible rates follow what forex traders think the currency is worth. Those judgments depend on a lot of factors. The three most important are 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. Here's more on why the dollar is so strong right now.
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. Here’s more about the underlying reasons behind the power of the U.S. dollar.
Fixed Exchange Rates
A fixed exchange rate is when a country's currency doesn't vary according to the forex market. 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 June 19, 2017, one dollar was worth 6.806 Chinese yuan. Since February 7, 2003, 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.
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 United States, more expensive. For more on how this affects you, see U.S. China Trade Deficit.
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. For more information, see Yuan to Dollar Conversion.
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 0.89 euros on June 26, 2016, you would only hear that one euro was worth $1.11. 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. For more information about 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. 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.