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How to calculate exchange rates

October 9, 2022

If you’ve ever sent money overseas, converter calculator currency you know how important it is to understand a country’s local currency and how it relates to the money you have. This is the idea behind how to calculate exchange rates and understand foreign currencies.

“Exchange rate”

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refers to how much of one currency you can trade for a different currency. For example, you could trade about 1 USD for 0.83 EUR. Or in other words, 1 EUR is equal to about 1.21 USD.

How are exchange rates calculated?

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Exchange rates are determined by foreign exchange trading (forex trading). Forex trading is an international market for buying and selling currencies, and it’s about 25 times larger than all the world’s stock markets.

Forex trading includes small transactions

like when you travel internationally and trade your currency for the local currency. It also includes large transactions, like when a business secures an exchange rate for the future. Forex trading happens all day, every day, and that’s why the exchange rate is always changing for most currencies.

These trades impact exchange rates because there is more money circulating in different economies. Since about 88% of the world trade is in US dollars, most exchange rate calculations are compared to this currency.

What are the different kinds of exchange rates?

There are two different kinds of exchange rates to be aware of around the world: flexible and fixed exchange rates.

Flexible exchasnge rate

Flexible exchange rates, which are used by many developed countries, depend on a country’s current supply and demand, and “self-correct” based on changes in the economy. With a flexible exchange rate, if the demand for a currency is low, its value will decrease. This makes imported goods more expensive and can stimulate the economy as consumers turn to local goods and services, generating jobs that contribute to a market correction. Since this cycle happens often, a flexible exchange rate is always changing.

When a country has a flexible exchange rate, this also means that the government or central bank doesn’t actively work to keep the exchange rate fixed or regulated. Instead, the forex market influences the exchange rate. For example, as of February 2021, the exchange rate was 1 USD to 0.83 EUR, but at the end of March 2020, it was about 1 USD to 0.91 EUR.

Fixed exchange rates

Fixed exchange rates are set and maintained by a country’s government, resulting in an official exchange rate. This set price is usually determined against a major international currency, like the US dollar.

For a fixed exchange rate to work, the central bank buys and sells currency on the forex market in return for the currency it’s compared against. For example, if a country fixes their exchange rate equal to 2 USD, they then supply themselves with enough US dollars to supply the market with that exchange rate. These reserves are called foreign reserves and help regulate market fluctuations, inflation, and deflation, and as a result, the country’s exchange rate.

What factors affect exchange rates?

One of the most common questions about exchange rates is “why do exchange rates change so frequently?” This is because they depend on several factors, such as interest rates, money supply, and financial stability.

Interest rates

Interest rates, inflation, and exchange rates are closely related because they directly influence each other. When financial institutions change the interest rate, this impacts currency values. Higher interest rates mean that lenders receive a higher return compared to other economies, which then motivates them to spend more money in that country. This leads to an influx in foreign capital, which causes the exchange rate to increase.

Decreasing interest rates have the opposite effect. As interest rates go down, so do exchange rates. In short, higher interest rates make a country’s currency more valuable, which drives investors to exchange their local currency for the higher-paying one.

Money supply

Money supply, or how much cash a country has on hand, influences both inflation and exchange rates. This is the money that the country’s central bank creates. If there is too much money in circulation, this causes inflation. This also means that the country’s currency isn’t worth as much because there is more of it.

When that currency is exchanged internationally, it’s not worth as much because there’s an excess, resulting in a decreasing exchange rate. This is what economists mean when they talk about how “strong” a currency is.

Financial stability

The country’s economic health plays a role in determining its exchange rate. If a country has a strong economy, people will buy its goods and services. This results in more international currency being injected into the local economy. On the flip side, things like financial instability or political turmoil can make international investors nervous and they may move their capital to more stable countries.

How to read an exchange rate

Currency conversion calculations are presented in pairs, which means that one currency is quoted against the other. For example, a 1 USD/CAD exchange rate means that 1 USD is equal to about 1.26 CAD. Usually, exchange rates are presented as a number, like 1.26, as in the case of the USD/CAD example

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