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The foreign exchange market is the global trading of currencies. Currencies are traded on both the large and small scale. Some governments mandate a fixed exchange rate between currencies rather than allowing the free market to set prices. Others use a floating exchange rate, which depends on the foreign exchange market to reach price equilibrium. A multitude of factors affect prices in the foreign exchange market, many of which are essentially unpredictable.
Individuals may participate in the foreign exchange market on the small scale for traveling purposes. Whether they obtain foreign currency ahead of time or not, they are a part of the global exchange market in currencies. On the larger scale, international banks and financial companies may trade in the foreign exchange market for revenue. If an institution can get a hold of a currency before its value rises, it can turn a profit by later re-exchanging the currency.
With a fixed exchange rate, however, governments set the exchange rate. Fixed exchange rates are preferred by many governments because they can help bring economic stability. Even before the euro currency was used, many European countries had agreements to link their currencies in an attempt to stabilize exchange rates. They were trying to prevent large fluctuations in exchange rates between countries, which was seen to cause instability and inflation. The euro effectively serves to lock in exchange rates permanently, as it has the same value in all member countries.
Other nations, including the US, have typically used a floating exchange rate. Since a floating exchange rate is determined by the foreign exchange market, it can rapidly change according to many different factors. Some have claimed the foreign exchange market closely resembles perfect competition because it is largely unregulated.
Political stability is one factor that can affect prices in the foreign exchange market. When social unrest threatens a government’s ability to exert authority, its currency value can suffer. Foreign traders, whether small-scale or large, will be reluctant to exchange a more stable currency for a less stable one. Unstable countries tend to suffer from reduced economic production, which offers holders of their currency fewer opportunities to redeem it. The reduced demand for less stable currencies directly causes them to lose value in the foreign exchange market.
Economic conditions also affect foreign exchange rates. For instance, if traders suspect inflation levels to rise in a foreign country, they will be reluctant to buy its currency. Inflation diminishes the purchasing power of a currency and, thus, reduces its demand. Rising gross domestic product (GDP), however, tends to increase the value of a currency. GDP is a measure of the overall strength of an economy and, therefore, increases confidence in its currency.