What You Need to Know
Exchange rates are prices of currencies on global markets
Floating rates change with supply and demand
Fixed rates are pegged by central banks
Each system has advantages and drawbacks
8 major factors cause exchange rate changes
Currency changes affect jobs, prices, growth, and trade
What is an Exchange Rate?
An exchange rate is simply the price of one currency expressed in terms of another. For example, £1 = €1.18 means one British pound buys 1.18 euros.
Think of currencies like any other product in a shop — they have a price. But instead of being bought and sold in high street stores, currencies are traded on the global foreign exchange market (forex). Every day, trillions of pounds, dollars, euros, and other currencies change hands. Companies buying goods from abroad, tourists exchanging money, investors moving savings between countries — they all need to buy and sell currencies, just like anyone buying apples or phones.
Foreign Exchange Market (Forex): The global market where currencies are bought and sold. It's decentralized (no single location), operates 24/5 globally, and is the most liquid financial market in the world — meaning currencies trade constantly and in huge volumes.
The central bank of each country plays a crucial role in deciding which exchange rate system to use — whether to let the market decide the currency's value, or to control it themselves.
How Floating Exchange Rates Work
In a floating exchange rate system, the market — pure supply and demand — determines the value of a currency.
The principle: When there's more demand for a currency than supply, its price rises (the currency appreciates). When there's more supply than demand, the price falls (the currency depreciates).
This is exactly like any market. If everyone suddenly wants to buy coffee but there's only a little supply, the price goes up. If the supply floods the market, the price crashes.
Real example: Europeans visit the USA and demand US dollars to pay for holidays, hotels, and shopping. This increases demand for $, so the $ appreciates. At the same time, Europeans supply their own euros to buy those dollars. This increases supply of €, so the € depreciates. Two things happen at once: $ goes up, € goes down.
The supply and demand mechanism:
Demand for currency ↑ → Price (exchange rate) ↑ → Currency appreciates
Supply of currency ↑ → Price (exchange rate) ↓ → Currency depreciates
How Fixed Exchange Rates Work
In a fixed exchange rate system, the central bank does not let the market decide. Instead, it pegs (fixes) its currency to another currency at a set rate.
For example:
- Hong Kong pegs its currency to the US dollar at HK$7.75 = US$1
- Brunei Dollar is pegged to Singapore Dollar at 1:1 (parity)
To maintain this peg, the central bank must constantly intervene in the forex market:
- If they want the currency to appreciate: They buy their own currency using foreign currency reserves, increasing demand for it
- If they want the currency to depreciate: They sell their own currency, increasing supply of it