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How do exchange rates work?

If you’ve ever swapped money before going abroad, you might wonder why you never get exactly the same amount. Read our guide to exchange rates to find why, and what they mean in the wider world.

What is an exchange rate?

An exchange rate is the amount one currency is worth in another at a given time. For example, on one day £1 might be worth US $1.3. The exact amounts change according to their value on the international exchange markets. These work in a similar way to stock markets, except that people are buying different kinds of currency rather than stocks and shares in companies.

According to the principle of supply and demand, if lots of people want to buy one type of currency then its value goes up, which is called appreciating, and if more people are trying to sell it than the value goes down, called depreciating. People might want to buy different currencies for various reasons. A company in the UK that gets paid in euros by a company in Germany might then use those euros to buy sterling so they can pay their staff in the UK, or if they want to invest in the German company, they might sell pounds sterling to buy euros to make the investment. Other people might ‘speculate’ on the foreign exchange markets by buying one kind of currency when its value is low, in the hope of making a profit by selling it when its value rises.

Different countries use one of two different systems to work out the exchange rate of their currency:

  • Floating systems mean that the value of a currency isn’t related to any other, and is worked out purely according to how much people will pay for it on the foreign exchange market. A floating system is used by most of the world’s bigger currencies, such as the US dollar, euro and sterling.
  • Pegged systems mean that the value of a country’s currency is always worth exactly the same amount of another, normally the US dollar. For example, two Belize dollars are always worth $1. A pegged system is normally used by smaller countries, who want more control over their economy.

How do exchange rates affect the economy?

Many people only notice the exchange rate when swapping money to go abroad. In this case, it’s a good thing if the currency they want to swap has a high value, as it means they can get more of the other currency for it.

A high value currency is normally also a sign that a country has a good economy, as it shows that people want to invest in the country by buying its currency. If an economy is in trouble people will usually try and sell its currency, which pushes its value down, as is happening in the euro crisis.

However, if a currency’s value is too high it can affect a country’s exports, since products made there become too expensive for people to buy abroad, which can damage the economy. In this situation a country’s central bank can try and bring the value down by selling some of the reserves of its own currency to buy another, for example using big amounts of sterling to buy dollars. Governments can also alter interest rates to try and control prices, although this can have a bad effect on inflation.

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