eli5: How are currency exchange rates set?
In: Economics
Most of the currencies are based on “floating rates”…. if there is more demand for the currency, it’s worth more (if more people are buying it up, it’s value increases) and vice versa! Also note that if the value is more and you compare it to the US Dollar, it should be closer to 1 i.e. 1 USD = 1 Unit of the currency (really really strong)
Its supply and demand in floating exchange rates. The supply comes from the government, foreign governments, imports and speculators and demand comes from the same forces except exports lead to currency demand.
In a peggged system its the same but the government interviens if a currency falls or rises beyoned a certain point.
In a fixed system the government controls the price of a currency
Usually, these rates are not “set”. Although a few countries try to regulate the rates of their currencies one way or another.
But in general, a currency is just one more thing whose value is determined by supply and demand. If more people want to buy dollars, the dollar will rise in value.
This supply and demand for currencies mostly comes from international trade: If a factory in Germany produces cars that get shipped to the USA and are bought there, then the customer pays in dollars, but the workers want to be paid in euros. Which means that the company needs to buy lots of euros with its dollars. So there is a demand for euros, and the euro’s exchange rate will rise.
Currency has value because we agree on it. At some point, we decided to make trade easier to create money to replace trading item for item. This was a success and the concept took root in other places.
Since all these places didn’t create the same currencies with the same value, it caused trouble when trading between places. So what happened in large trading cities is that they had what was basically a place you can exchange one currency for another.
To decide the exchange rate at that time, they used the following method (Extra simplified)
In country A with Money A (MA) the pound of grain cost 3 MA.
In country B with Money B (MB) the pound of grain cost 2 MB.
Thus, 3MA = 2MB.
Of course, in reality, the math was much more complex, they were not only comparing the price of grain but other commodities and drawing an average. Another thing of note is that there is an extra “service” fee on the exchange rate. The bank has to pay its employees and its security for holding and taking care of so many different currencies. The fee is there to pay for these services.
Another thing of note: in many case the biggest thing they compared values of was gold and silver. As most currencies were made with them, if MA and MB had the same amount of gold to make them, but had different value, people would smelt the low value one to make the high value one causing problem in the economy. So in most cases, the thing they were trying to equalize was the value of the material the currency is made of.
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