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 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 June 19, 2017, you'd only receive 0.77 pounds for your dollar. You'd get a little less than the exchange rate since banks charge a fee. Conversely, a pound is worth $1.29.

  

Flexible Exchange Rates

Most exchange rates are determined by the foreign exchange market, known as forex. That's known as a flexible exchange rate. For this reason, exchange rates vary 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 central bank interest rates, the country's debt levels and the strength of its economy. 

America allows the forex market to determine the U.S. Dollar's Value. The dollar strengthened against most currencies during the 2008 financial crisis. 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. 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. Find out the underlying reasons behind the power of the U.S. dollar

Fixed Exchange Rates

fixed exchange rate is when a country's currency doesn't vary according to the forex market. The country makes sure its value against the dollar, or another important currency, remains 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. The dollar has weakened against the yuan since February 7, 2003, when a dollar could be exchanged for 8.28 yuan. It's weakened because it can buy fewer yuan in 2017 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 U.S. 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. It wants to reduce its reliance on the dollar. It also wants the yuan to be more widely traded. 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. In that way it is similar to the British pound.

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 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.

In March 2015, the ECB announced its version of Quantitative Easing. That sent the euro's value plummeting to $1.10. 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. 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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