How Does a Currency Exchange Rate Work?
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What is an Exchange Rate?
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A currency exchange rate is the value of a certain world currency with respect to another currency, U.S. dollars to Euros for example. Exchange rates are typically quoted as a ratio with either one of the currencies being set equal to one, such as 1 U.S. dollar = 0.75 Euros. Oftentimes the currency which is worth more for a single unit is set to equal one so that the ratio can be more easily understood, since fractions of a unit can become confusing. For example, the Japanese yen is worth significantly less than a dollar, so the quote 1 U.S. dollar = 110 yen, is more useful to most people than 1 yen = 0.091 U.S. dollars. Currency exchange rates are an important part of international trade and economics, since to buy goods from or travel in foreign countries, one must exchange money into the currency of the foreign country.
Why do Exchange Rates Fluctuate?
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One of the most important aspects of currency exchange rates is that the value of a certain currency will fluctuate with respect to another. The value of a given currency rises and falls with supply and demand of that currency, which in turn, determines the exchange rate. For instance, if the U.S. set very high interest rates, foreign savers might want to save in U.S. financial institutions and demand dollars, which would increase the relative value of the dollar. On the other hand, if the government decided to print a large amount of new paper currency, the money supply would increase, diluting the value of existing dollars. Any economic factor which influences demand for currency and prices stands to affect exchange rates.
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Undervalued and Overvalued Currency
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Another important aspect of currency exchange is the tendency for certain currencies to become overvalued or undervalued. The value of a currency can derived from its ability to purchase a certain bundle of goods. If exchange rates perfectly reflected the purchasing power of money, one would be able to exchange money from one currency to another and purchase the exact same bundle of goods in either country. What one often finds, however, is that certain currencies enable one to purchase much more in one country than another. For example, a U.S. shopper might be able to buy two pairs of jeans in the U.S., but 10 pairs of jeans if they were to travel to China and covert those dollars to Yuan. There are many reasons currencies can become overvalued or undervalued, such as governmental controls on exchange rates, government instability and trade balance.
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