How Are Currency Exchange Rates Determined?

How Are Currency Exchange Rates Determined?

by Manish Singh

Looking at exchange rates will give you insights into different markets. For example, looking at the dollar-to-euro exchange rate for US-based investors can be very informative when looking to invest in Europe.

A falling US dollar could positively affect international investments because foreign currency assets are cheaper to buy (i.e., USD to INR). However, a rising dollar could negatively affect international assets as foreign currencies become more expensive to purchase.

Foreign Exchange and Commodities

The correlation between a country’s domestic industry and its currency is one of the fundamental laws of economics, and it can have a significant impact on forex traders. As a result, you should often look at the commodity prices of the country’s key industries if you want to predict a country’s currency’s movement. Thus, when analyzing currencies, traders can use this tool as a method for forecasting price movement.

Maintaining Exchange Rates

Currencies pegged to the US dollar tend to follow the dollar’s movements. Thus, if the dollar falls, so does the currency pegged to it. When this happens, countries can follow several strategies to offset the losses and keep the currency pegged.

For example, a strategy that countries can use is simply adjusting their interest rates or using investment instruments directly affecting the local economy. These methods can help stabilize the currency while still maintaining its peg to USD as well.

Induced Exchange Rates

The biggest influence on exchange rates is supply and demand. When demand for the US dollar goes up, the dollar will rise in value relative to other currencies like the Euro or pound. It’s also possible to look at a currency’s relative strength. We expect weak currencies like the Mexican peso to have higher inflation and interest rates. If there’s more demand than supply for a currency — that’s when it increases in value.

If there is an imbalance in the supply and demand of currencies, its exchange rate will shift accordingly. News related to a country’s political stability, economic strength, or production levels can cause changes in the demand or supply of a currency. In essence, these factors are fundamentals that indirectly affect currency rates.

Comparative Study of Floating and Fixed Exchange Rates

The floating-rate model — determined by supply and demand on global currency markets — is a more accurate representation of the value of a currency in the modern world.

Meanwhile, a fixed rate remains tethered to a fiat currency like the United States dollar or the Euro. This can be problematic because fluctuations in the value of the fiat currency against other markets will similarly affect its foreign exchange counterpart.

Macro Factors

Macroeconomic factors are one of the main factors that affect exchange rates. The “law of one price” says that a good should be the same price worldwide — with free trade, it should be able to move freely from market to market. If prices get out of whack, two things can happen: interest rates can shift in a country, or else the exchange rate can shift between currencies.

Thank you for reading this content about exchange rates. We hope we’ve been able to give you a better understanding of how they work — and how to take advantage of currency fluctuations.

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