How Do Foreign Exchange Rates Work
Ladies and gentlemen! In this post I will reveal unto you the secret workings of the foreign exchange rates. This might strike your curiosity if you’re thinking about emigrating and want to get the best exchange rate, deal with changing currencies as part of your business, or just happen to be someone that likes learning (highly commendable too, I daresay.) Sit tight, and hold onto your hats!
The foreign exchange rates work as follows. On this planet there are currencies, issued by nations and international groupings of nations. For example, the UK pound is issued by the government of the United Kingdom, while the euro is issued by the Eurozone group of nations. The inhabitants of these nations live and work, and receive restitution for their labours (usually) in the currency of the nation they’re presently living in. Hence, someone working in the USA is paid in US dollars.
However, it so happens that sometimes people want to move to other countries, and trade with them also. In this case, these people must change their existing currency to the one of the nation they’re hoping to deal with. This is where the foreign exchange rates comes in.
Because unfortunately, it is not the case that someone in California hoping to move to Paris changes his or her US dollars into euros at a fixed rate. Someone with a hundred thousand dollars does not get a hundred thousand euros when they change currencies. Instead, the value of a currency is relative to other currencies, depending on the economic and political state of the countries involved.
In other words, the value of the US dollar is determined in large part by the perceived economic condition of the US as a whole. This is just the basis for a currency, and has been this way ever since the abandonment of the Gold Standard post-WWII (see the famed Bretton-Woods agreement in 1944.)
So for instance, when someone has US dollars and hopes to change them into euros, the value of the US dollar is assessed according to the strength of the US economy relative to the strength of the Eurozone. If it looks like the US economy is getting stronger, the US dollar gets stronger, and equally if it looks like the Eurozone is getting weaker, that is also likely to strengthen the dollar against the euro.
In effect then, the foreign exchange rates are a system of comparison, in which exchange rates are set depending on the assessment of the strength of the economies involved.
It is the inhabitants of the foreign exchange market who make these assessments, buying and selling currencies depending on which they think is the better investment. So if the US dollar goes up against the euro, it is because investors on the foreign exchange market believe the US a better bet relative to the Eurozone. I hope that helps!
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