You will likely have noticed that currency exchange rates don’t tend to be static; in fact they can vary greatly from day to day. Some people actually use the fluctuation currency exchange rates as a means to make a profit; buying at one rate and selling at another. You may be wondering though, how exactly are these currency rates decided in the first place. Who decides how much a dollar is worth when compared to the Euro? You may also be asking yourself why they just don’t pick an exchange rate and just stick with it; instead of this constant fluctuation.
The Process of Determining Currency Exchange Rates
A full understanding of how currency rates are determined is a complex issue that would be way beyond the scope of one small article on the subject. It is possible though, to provide a very basic introduction to the subject.
The simplest way of looking at exchange rates would be to discuss purchasing power parity. Imagine that a loaf of bread cost $2 in the United States and €1 in Europe. As far as purchasing power parity is concerned €1 is worth $2 and $1 is worth 50 European cents. This is a very simple explanation and the currency exchange rate involves much tougher calculation that this.
On a day to day basis the value of a currency is usually determined by the demand and supply of that currency. If the demand is greater than what is supplied then the price of a currency will tend to rise. If many people are selling and nobody wants to buy then this would cause a fall in the value of the currency.
There are a number of reasons why the demand for a currency can go up or down. One of these reasons is the need for a currency for transaction purposes. For example, if I live in Holland and you live in America I will need US dollars to buy your products. There are millions of transactions like this occurring around the world and the demand for different currencies will depend on how much is needed for transactions. Another reason why the demand for a currency can rise or fall is speculation; investors will buy or sell currency in the belief that the value of it will later rise or fall. The reason why currency rates are constantly changing then is closely connected to supply and demand.
