How Exchange Rates Work

Currency exchange rates result from the equilibrium price obtained from the relative demand and supply of one countries currency relative to another countries currency. The globalization of trade and investments has made it easy for countries, companies and individuals to purchase goods and make investments across the globe. To pay for these goods and investments, foreign currencies have to be traded and the act of trading in currencies leads to currency exchange rates.

 An example of how exchange rates work is the relationship between the Yen and the Dollar. If there is a net increase in demand by the Japanese for American goods and services relative to the level of demand by Americans for Japanese goods and services, then the dollar should appreciate relative to the Yen. The dollar appreciates due to the increase in demand for dollars by the Japanese, as a result of the increased demand for American goods and services. 

Demand for a currency will always be the primary determinant of the value of that currency relative to other currencies. This is also true in cases where there is a relative differential in interest rates. If interest rates in Japan are relatively higher then interest rates in the U.S., then U.S. investors will demand Yen, so they can invest in Japan and take advantage of the interest rate differential. The demand for Yen will lead to an increase in the value of the Yen relative to the dollar. The sale of dollars to buy Yen will depress the value of the dollar. 

The relative inflation rate between countries also influences the exchange rates between the countries, since inflation makes goods and services more expensive. If the current exchange rate between the U.S. and Yen is 50 Yen per 1 U.S. dollar and inflation in the U.S. rises over a period by 10%. Again assume that a loaf of bread in the U.S. costs 1 dollar and the same loaf of bread cost 50 Yen in Japan, the increase in the inflation rate in the U.S. will lead to an increase in the loaf of bread from 1 dollar to 1.10 dollars. The same loaf of bread in Japan still costs 50 Yen. Hence the 1 U.S dollar that was worth 50 Yen is now worth 50/1.10 = 45.5 Yen. This example illustrates the negative effects of persistent inflation on exchange rates. 

Another significant contributing factor to exchange rates is the perceived level of safety of a given currency. For many years, the U.S. dollar has been the international currency for trading many commodities. Oil prices are quoted in dollars per barrel. Likewise, central banks all over the world keep their surpluses either in gold or in a stable currency. The more demand there is for a currency that is perceived to be stable, the higher the exchange rates become between the countries that purchase the stable currency and the countries whose currency is being purchased. 

Exchange rates are a critical part of foreign trade and affect the viability of a countries currency. Many countries try to strengthen their currencies by reducing their debt, increasing their exports and maintaining stable and attractive interest rates. A weak currency can be an advantage for a country with a significant manufacturing economy and hence significant exports, since their goods and services will be cheaper if their currency weakens relative to their trading partner’s currencies. On the other hand, central banks and international investors that are looking for a stable currency will shy away from a currency that is weak, since their investments will be worth less when they convert the weak currency back into their currency.