What Determines an Exchange Rate?

When traveling abroad, you'll have to exchange the currency of your origin country for that of your destination, but what determines the rate at which these are exchanged? In short, the exchange rate of a country's currency is determined by its supply and demand rate in the country for which currency is being exchanged.

Exchange rate sites such as XE.com make it easier for people to plan their trips abroad, but it's important to note that along with an increase in cost for foreign currency oftentimes comes an increased price of goods and services there.

Ultimately, a variety of factors influences how a national's currency, and in turn, its exchange rate, are determined, including supply and demand of goods by foreign consumers, speculations on future demands of currency, and even central banks' investments in foreign currencies.

Short-Run Exchange Rates Are Determined by Supply and Demand:

Like any other price in local economies, exchange rates are determined by supply and demand — specifically the supply and demand for each currency. But that explanation is almost tautological as one must also know we need to know what determines the supply of a currency and the demand for a currency.

The supply of a currency on a foreign exchange market is determined by the following:

  • Demand for goods, services and investments priced in that currency.
  • Speculations on future demands of that currency.
  • Central banks occasionally buy up foreign currency to affect the exchange rate.

    To put it simply, demand relies on the want for a foreign traveler in Canada, for instance, to buy a Canadian good like maple syrup. If this demand of foreign buyers rises, it will cause the Canadian dollar value to rise as well. Similarly, if the Canadian dollar is expected to rise, these speculations will affect the exchange rate, too.

    Central banks, on the other hand, don't directly rely on consumer interaction to affect the exchange rates. While they can't simply print more money, they can influence investments, loans, and exchanges in the foreign marketplace, which will either raise or lower the value of their nation's currency abroad.

    What Should The Currency Be Worth?

    If speculators and central banks can affect both the supply and demand for a currency, they can ultimately affect the price. Thus does a currency have an intrinsic value relative to another currency? Is there a level the exchange rate should be at?

    It turns out there is at least a rough level to which a currency should be worth, as detailed in the Purchasing Power Parity Theory. The exchange rate, in the long run, needs to be at the level which a basket of goods costs the same in two currencies. Thus, if a Mickey Mantle rookie card, for instance, costs $50,000 Canadian and $25,000 U.S., the exchange rate should be two Canadian dollars for one American dollar.

    Still, the exchange rate is actually determined by a variety of factors, which change constantly. As a result, it's important when traveling abroad to check the current exchange rate in destination countries, especially during peak tourist season when the foreign demand for domestic goods is higher.