Exchange Rates: What They Are, How They Work, Why They Fluctuate (2024)

FAQs

Exchange Rates: What They Are, How They Work, Why They Fluctuate? ›

An exchange rate is the rate at which one currency can be exchanged for another currency. Most exchange rates are defined as floating

Currency fluctuations are a natural outcome of floating exchange rates, which is the norm for most major economies. Numerous factors influence exchange rates, including a country's economic performance, the outlook for inflation, interest rate differentials, capital flows and so on.

The exchange rate gives the relative value of one currency against another currency. An exchange rate GBP/USD of two, for example, indicates that one pound will buy two U.S. dollars.

Currencies constantly fluctuate in value as they are traded on the international market known as the forex or FX. Currency trading is dominated by banks and institutional investors that are exchanging money for their business customers or making a profit from fluctuations in currency prices.

The Kuwaiti Dinar is renowned as the strongest currency in the world. Introduced in 1961, it has maintained a commanding presence due to Kuwait's substantial oil reserves, which account for a significant portion of its economic output.

Most exchange rates are floating and rise or fall based on the supply and demand in the foreign exchange market but some are pegged to another country's currency or are fixed in value.

Overview of Exchange Rates

A rise in the value of its currency makes a nation's imports less expensive for its citizens to buy and its exports more expensive for consumers in foreign markets. 1 A decrease in the value of its currency makes its imports more expensive and its exports less expensive in foreign markets.

A fixed or pegged rate is determined by the government through its central bank. The rate is set against another major world currency (such as the U.S. dollar, euro, or yen). To maintain its exchange rate, the government will buy and sell its own currency against the currency to which it is pegged.

Exchange rates are affected by numerous factors including the perception of stability of the financial system of the issuing currency, the interest rate set by the host country's central bank and the demand for the goods and services (exports) the country produces.

How to know which currency is stronger? ›

A currency's strength is determined by the interaction of a variety of local and international factors such as the demand and supply in the foreign exchange markets; the interest rates of the central bank; the inflation and growth in the domestic economy; and the country's balance of trade.

Interest rate movements are based on the simple concept of supply and demand. If the demand for credit (loans) increases, so do interest rates. This is because there are more buyers, so sellers can command a better price, i.e. higher rates.

Price, productivity, labour wedge, government spending and mark-up shocks all impact output or consumption and the exchange rate.

Currency valuations fluctuate constantly, driven by the flow of funds between markets. The two biggest drivers are central bank policies (interest rates set by the U.S. Federal Reserve and its counterparts in Europe, England, Japan and elsewhere); and economic growth relative to inflation.

Technology changes that cause productivity increases in goods commonly traded between countries, called tradables, are thought to be one of those factors. Because productivity increases lead to lower production costs, the REERs would rise to maintain equilibrium.

Currencies increase in value when lots of people want to buy them (meaning there is high demand for those currencies), and they decrease in value when fewer people want to buy them (i.e., the demand is low).

1. Economic indicators: Inflation and government debt. Inflation rates impact a country's currency value. A low inflation rate typically leads to a rising currency value, as its purchasing power increases relative to other currencies.