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How are Currency Exchange Rates Set?

Inflation, interest rates and trade value all impact currency exchange rates.
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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 02 December 2014
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The currency exchange market is often said to be the largest investment market in the world. However, many people do not know how the process of determining the value of one currency in relation to another takes place. Essentially, currency exchange rates are set based on several basic factors that are consistently applied in all situations, as well as some factors that may vary, depending on the circumstances.

The fixed factors that impact currency exchange rates are generally identified as inflation, interest rates, and trade value. Trade value has to do with the ratio of business and service trading that takes place between the two countries that issue the currency. In the event that one country purchases more goods and services from a given country than it imports to that same country, the value of the each country will reflect that difference. In effect, the country that gains the most from the sale of goods and services between the two countries will have a currency that is rated higher in value.

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Inflation and recession are economic factors that directly impact the ability of a country to purchase goods and services, both within the country and on the world market. High inflation will mean that the country will be less capable of purchasing goods and services. Decreased purchasing power will lead to the currency of that country being considered less desirable. Since the idea of exchanging currency is to maximize the worth of the investment in currency, inflation will directly lead to a depreciation of the worth of that nation’s currency in comparison to that of a country that is not currently experiencing inflation. Thus the currency exchange rate between the two countries shifts, until the period of inflation passes.

Directly related to inflation is the matter of interest rates. Also an important economic indicator, high interest rates mean less circulation of money through loans. Less money in circulation means less purchasing on the world market. This means that currency exchange rates for that country will also drop in value.

These three main factors in evaluating currency exchange rates, like other less relevant factors, can change in a matter of hours. That is one thing that makes investing in currency exchange such an exciting venture. The level of challenge with currency exchange rates can also be heightened when such issues as political turnovers and natural disasters also impact the economic nature of a country, and thus dictate a change in currency exchange rates for that nation’s currency.

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Discuss this Article

anon331073
Post 9

For real. I hate when they are giving me vague answers on how the exchange rate is calculated. For instance, I would ask how the price of rice is calculated. First, they would tell me that the cost of the raw materials would factor into this price determination, their expenses, and taxes they have to pay to the government, etc.

zmunford
Post 8

I really want to know myself. I am tired of hearing answers like "the interaction of the forces of supply and demand" determines the exchange rate or "players and their speculations" determine exchange rates.

Who actually sets the rate like "1 usd to 1.5 Gb pounds"?

How is this rate arrived at? I am really interested in the origin of the figure. Can somebody help me please?

anon149190
Post 7

Ok, simple question that I can't seem to find the answer to no matter how much I search: The exchange rate listed on so many sites--who put this number down? There is never a source listed. I mean who decides the number, as in if I were to ask about why cereal at my local grocery is $4, I don't want to hear that it is priced by supply and demand. I want to hear that the grocery store owner decided on that price.

noobbaba
Post 6

You mentioned “trade values” as an important factor in determining currency exchange. Might you tell me what organization is responsible for calculating it? Do those organizations have the authority to make fair exchange rate in global market?

What if some countries refuse to raise their exchange rate under a imbalance “trade value”, for example China? What other countries may do?

anon127394
Post 4

Yes anon69271, I've been eager to know the answer to that too. All I read is garbage and not one article gives me an answer. So how does the currency fluctuation and where is this computer that has the unknown magic formula? I'd love to know.

anon118714
Post 3

@Anon69271:

On a theoretical level, currency exchange rates are determined by supply and demand. The problem is the supply demand formula for currency exchange rates is a hulking monster of a thing with many many variables. It is no S=2d that you can just plot on an x-y axis. Although there probably is some regression equation out

there that will explain a large portion of what factors help determine the exchange rate (I'm actually trying to come up with one right now for a paper I'm writing), there will never be one equation to perfectly explain it. Supply and demand come down to human behavior. (holding conspiracy theories about colluding international banks constant).

You will never find a clean and easy calculation for currency exchange rates (or any other sort of speculative market for that matter) If you do, get yourself onto a forex broker and make your millions.

anon90388
Post 2

Yeah how come the formulas seem secret?

anon69271
Post 1

You know, at some point in history, someone came up with a math formula to determine 'currency value'. But all I find on the internet is mumbo jumbo!

U.S. currency was backed by gold, but now its not. It floats up and down based on buyers and sellers! But some countries don't want their currencies strong. Please don't tell me what its based on. Tell me the formulas!

For example, how many buyers to sellers (countries), make '1' Euro to the U.S. 1.36? Etc.

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