- 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.
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.
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.
Three Factors Affecting Exchange Rates
- 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. That 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 will push the value of a currency down.
- Third, a country’s economic growth and financial stability impact its 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.