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How Do Exchange Rates Work?


Question: How Do Exchange Rates Work?
Answer: Exchange rates tell you how much your currency is worth in another currency.

Fixed exchange rates only change when the government says so. These rates are usually pegged to the U.S. dollar. To keep the exchange rate fixed, the central bank must buy and hold a large amount of its currency. If the value of the country's currency rises, the bank must release large amounts of it to keep the price low. If demand for its currency falls, the bank must buy up large amounts of its currency. Some of these most well-known currencies are the Chinese yuan and the Saudi Arabian riyal.

You are probably more familiar with flexible exchange rates, which change every day. That's because these currencies are traded on the forex market.

What Affects 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 want to exchange their currency for the higher-paying one, and save it in that country's bank to receive the higher interest rate.

Second, inflation will push down the value of a currency. A high inflation rate makes that country's currency worth less the longer it's held.

Third, a country's financial stability also impacts a currency over time. Investors want to be sure they will get paid back if they hold government bonds in that currency. Article updated September 30, 2013

Exchange Rates FAQ

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