How are exchange rates determined and who enforces them? How does a country buy its own currency and what does that mean?
In: Economics
Exchange rates are not enforced. There is always someone who owns money and sells it for a given price. Most of the time banks take that role.
Usually when somebody buys a lot of currency the value goes up and when there is a lot to sell the price goes down. Countries buy their own currency from banks or exchanges to drive up the value of their currency and pay that with foreign currency they received from trading or by borrowing.
Demand and supply, as usual.
1) If country A exports a lot to country B and B doesn’t export that much to A, a lot of people, companies,… in country B will buy things in country A’s currency
2) If country A is “stronger”, shows more growth,… than B, investors will be more likely to invest in country A’s currency hoping it’s a good investment.
No one enforces the exchange rates if it’s a freely traded currency like USD, EUR, JPY. Some currencies have centrally set exchange rates, where the central monetary body, usually a central bank, either sets the rate and then participates in the market to maintain it, or just prohibits transactions in foreign currency unless exchanged at the official rate.
Rates are determined on the foreign exchange markets by entities needing currencies. If I’m a BMW dealer taking delivery of a shipment of cars, at some point along the way, the dollars spend to pay for the inventory has to be converted into Euros to pay the German factory workers and parts suppliers. Conversely, the Dutch bakers need for American flour means at some point a grain importer needs to convert the Euros the baker pays for that flour into dollars to pay the American farmers who grew the wheat. Depending on demand and supply one way or the other, currency values fluctuate.
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