Currency exchange rate
Currency exchange rate is the value of one currency in relation to another. Currency exchange rates can be fixed or flexible. If you’ve traveled to foreign country, you have a first-hand experience of what currency exchange is all about. You basically trade American dollars for its equivalent in British pounds, Japanese yen, Mexican peso, or any other currency. There are a variety of factors that will affect currency exchange rates. In this section, we’ll give you an overview on how currency exchange rates work:
Having a national currency is a necessity for a country to be part of the modern economy. It allows nations to express the value of goods and services across borders. The exchange rates determine how much equivalent money you will get by trading in your currency. For example, if you decide to travel to the UK, you will need to exchange a certain amount of US dollars (say US$1,500) to British pounds (which will be roughly 1,000 pounds).
Methods of Exchange
There are two main systems that determine a nation’s exchange rate. They may either use a fixed (pegged) currency or flexible (floating) currency.
In the fixed currency system, the exchange rate is set artificially and this is maintained by the government. Usually, the nation’s exchange rate will be pegged to another currency, mostly the US dollar. The rate will not fluctuate on a daily basis. To make the fixed exchange rate work, the government must have large reserves of foreign currency to address changes in supply and demand.
In the floating currency system, the market determines the value of the money. It is worth what buyers are willing to pay for it. Floating currency fluctuates on a daily basis because it is based on supply and demand. Generally, countries with a stable and mature economy typically choose to have a floating currency as it is considered more efficient. The market automatically corrects the rate to reflect a host of economist forces including inflation.
In actual practice, very few currency exchange rate systems are 100% fixed or 100% flexible. For example, countries that use fixed exchange rates periodically review their peg. They can make adjustments based on market factors to avoid inflationary catastrophes. Meanwhile, countries that use floating exchange rates may make changes to influence the exchange rate. Among some measures at their disposal include import tariffs, tax cuts, and changes to the national interest rate.
Naturally, everything that can be priced continuously (or almost continuously) can - and usually is - subject for speculation and the currency exchange rates are no exception. Conversely, the FOREX (FOReign EXchange) market is the biggest market there is with enormous liquidity.