Exchange rate: An exchange rate tells you the value of your currency in anothercountry's currency.
An exchange rate tells you the value of your currency in anothercurrency. Think of it as the price being charged to purchase that currency. For example, in June of 2022, 1 euro was equal to 1.05 U.S. dollars, and 1 U.S. dollar was equal to 0.95 euro. Exchange rates indirectly affect many aspects of your life, from the cost of groceries to interest rates and employment opportunities.
Key Takeaways
- An exchange rate determines how much of another country's currency your own currency can buy.
- For some countries, exchange rates constantly change; others use a fixed exchange rate.
- The economic and social outlook of a country will influence its currency exchange rate versus other countries' currencies.
- Exchange rates are used for applying value to currencies across countries, whether for international trade or individual transactions by travelers.
Definition and Examples of Exchange Rates
When determining a particular country's exchange rate for your currency, there are a few factors to think about. For example, there are two kinds of exchange rates: flexible and fixed. Flexible exchange rates change constantly, while fixed exchange rates rarely change.
Flexible Rates
Most currency exchange rates are determined by theforeign exchange market, or forex. Such rates are called flexible exchange rates. For this reason, exchange rates fluctuate on a moment-by-moment basis.
Prices change constantly for the currencies that Americans are most likely to use. These include Mexican pesos, Canadian dollars, European euros, British pounds,and Japanese yen.These countries use flexible exchange rates. The government and central bank don't actively intervene to keep theirexchange rates fixed. Their policies can influence rates over the long term, but for most countries, the government can only influence, not regulate, exchange rates.
Fixed Rates
Other currencies, like the Saudi Arabian riyal, rarely change. That's because thosecountries usefixed exchange ratesthat only change when the government says so. These rates are usually pegged to the U.S. dollar. Their central bankshave enough money in their foreign currency reserves to control how much their currency is worth.
To keep the exchange rate fixed, the central bank holds U.S. dollars. If the value of the local currency falls, the bank sells its dollars for local currency. That reduces the supply in the marketplace, boosting its currency's value. It also increases the supply of dollars, sending the dollar's value down. If demand for its currency rises, it does the opposite.
The Chinese yuanused to be a fixed currency. Now, the Chinese government is slowly transitioning to a flexible exchange rate. That means it changes less frequently than a flexible exchange rate, but more frequently than a fixed exchange rate. As of June 2022, 1 U.S. dollar was worth about 6.69Chinese yuan. Since May 2005, the U.S. dollar has weakened against the yuan. One U.S. dollar could be exchanged for 8.28 yuan at that time. Saying the U.S. dollar has weakened means it can buy fewer yuan today than it could in 2005.
Bitcoin Exchange Rate
When it comes to cryptocurrency, bitcoin's value varies depends on the holder's financial circ*mstances and investing goals. Unlike the dollar, euro, pound, yen, peso, and other government-backed currencies, cryptocurrencies are not officially supported by any central bank or government. The currency traditionally has traded in an open marketplace similar to the stock market, where buyers and sellers can exchange their local money forbitcoin,or vice versa.
Bitcoin's price, most often quoted in terms of U.S. dollars, is publicly available at any time through most cryptocurrency exchanges, along with cryptocurrency news and market websites.
How Exchange Rates Work
Most exchange rates are given in terms of how much a dollar is worth in the foreign currency. But that's not usually true with the euro. Not surprisingly, theU.S. dollar and euro are the two most commonly quoted currencies, due to their status asreserve currenciesat many global central banks. The most popular currency pair is, therefore, the EUR/USD.
Euro Conversions
Theexchange rate for dollars to eurosis different from most other world currencies. 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 1 U.S. dollar was worth 0.95 euro in June 2022, you would instead hear that 1 euro was worth $1.05.
The euro has weakened considerably since April 2008. At that time, the euro was at its all-time high of $1.60. Since then, the future of theEuropean Unionand the euro itself has been in doubt after the U.K. voted to leave the European Union.In addition, theEuropean Central Bank (ECB)has been lowering itsinterest 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 ofquantitative easing in March 2015. That droppedthe euro's value to $1.10. The euro also weakened during theGreek debt crisis.
Three Factors Affecting Exchange Rates
Interest rates, money supply, and financial stability all affect currency exchange rates. Because of these factors, 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 willexchange their currency for the higher-paying one. They thensave it in that country's bank to receive the higher interest rate.
Second is the money supplythat'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 createsinflation. If way too much money is printed, it causes hyperinflation.
Note
Hyperinflationusually only happens when a country must pay off war debts.It's the most extreme typeof 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 currencybecause there's so much of it. That's why inflation can push the value of a currency down.
Third, a country's economic growth and financial stability affect its currency exchange rates. If the country has a strong, growing economy, then investors willbuy its goods and services. They'llneed more of their 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.
How To Check the Exchange Rate
If you're traveling overseas to another country that uses a different currency, you must plan for exchange rate values. When the U.S. dollar is strong, you can buy more foreign currency and enjoy a more affordable trip. If the U.S. dollar is weak, your trip will cost more, because you can't buy as much foreign currency for the same amount of dollars.Because the exchange rate varies, you might find that the cost of your trip has changed since you started planning it. This is just one of the waysexchange rates affect your personal finances.
You can search online to find the exchange rate of the U.S. dollar to foreign currency for any given day. Google has a tool to help with this. It even shows a chart indicating whether the dollar is strengthening or weakening.If it's strengthening, you can wait until right before your trip to buy your currency.
Note
Check to see whether your credit card company charges conversion fees. If not, then using your credit card overseas will get you the best exchange rate.
If the dollar is weakening, you might want to buy the foreign currency now, rather than wait until you travel. Banks charge a higher exchange rate, but it might be cheaper than what you'll pay in the future.
Frequently Asked Questions (FAQs)
What is a floating exchange rate?
A floating exchange rate is the same thing as a flexible exchange rate. When an exchange rate can change, people refer to it as "floating." The rate "floats" with market forces. Similarly, bonds with variable interest payments are known as floating-rate bonds.
What is the spot exchange rate?
The spot rate is simply the exchange rate at that moment ("on the spot").
