What is the exchange rate, and how do currency values fluctuate

1. The price of one currency in terms of another is known as the exchange rate, and it has a direct impact on the cost of your trip and imported goods.

2. Global variables like interest rates, economic news, and political stability cause currency values to fluctuate constantly.

3. While a weak currency has the opposite effect on a country's trade, a strong currency lowers the cost of imports while hurting exports. 

The exchange rate shows a nation's currency value in terms of another and impacts tourism, trade, and import prices.

Example:

Jetha Lal is excited about his trip to the US from India! Before leaving, he needs to swap his Indian Rupees (INR) for US Dollars (USD). The exchange rate shows how much he’ll get in dollars for his rupees.

Table:

Consider the following hypothetical rates for different currencies against the USD:
 

This table shows how USD's value varies globally. For example, with the Indian Rupee at 83.5 to one USD, Jetha Lal gets fewer dollars for his savings, making his trip to the US costlier.

This blog is your guide to understanding exchange rates. We'll also explore what causes these rates to change in our upcoming topic, "How Exchange Rates Fluctuate." 

How Exchange Rates Fluctuate

Exchange rate fluctuation refers to the constant changes in the value of one currency compared to another. This happens in the global foreign exchange market, which is the largest financial market in the world. 

The value of currencies isn't fixed; it fluctuates based on supply and demand. Various market trends, political events, and economic conditions can lead to these sudden changes.

Example:

Meet Mayank, a travel YouTuber who loves exploring new countries. He planned an exciting trip to Japan but thought he'd wait a bit before changing his Indian Rupees (INR) into Japanese Yen (JPY).

However, while he hesitated, something unexpected happened. Investors began to pull away from emerging markets, such as India, and focused more on Japan's robust economy. This shift caused the value of the Indian Rupee to drop and the Japanese Yen to rise.

Now, when Mayank finally exchanged his rupees, he found that he could get fewer Yen for the same amount of money, which meant his travel costs went up. As a result, he had to go back and adjust his budget for the trip.

Table:

The following table outlines the primary factors that cause these daily fluctuations:
 

This table shows that a currency's value often reflects a country's economic situation and global perception, shaped by various interconnected factors.

Key mechanisms through which these factors cause fluctuation include:

• Free-Floating Rates: Most major currencies (USD, EUR, JPY) use this system, where their value is determined purely by market forces without government intervention.

• Fixed or Pegged Rates: Some currencies (like the Hong Kong Dollar) are pegged to a stable currency like the USD. Their value is maintained within a narrow band by the country's central bank, which actively buys and sells its currency.

• Spot Rate vs. Forward Rate: The spot rate is the current market price. The forward rate is an agreed-upon price for a future transaction, based entirely on expectations about interest rates and economic policies.

Getting a grip on these key points is really important for anyone working in international finance. They help determine the cost of doing business in different countries.

Now that we know why exchange rates change, let's look at how these changes affect the supply and demand of goods.

Bonus Tip: A good strategy is to monitor rates and exchange a small amount when the rate is decent, avoiding the pressure to change all your money at once at the last minute.

How Exchange Rates Affect the Supply and Demand of Goods

Supply and demand curves can be influenced by exchange rates, which directly affect the prices of imported and exported goods. When a country's currency is strong, it makes imports cheaper and exports more expensive for overseas buyers. 

Conversely, if the currency is weak, imports become more expensive and exports become more affordable.

Example:

Nitin imports coffee machines from Italy to sell in India. If the Indian Rupee (INR) weakens against the Euro (EUR), each machine becomes more expensive for him. To maintain his profits, he must raise his prices, which may result in a decrease in demand from his local customers.

Table:

The following table summarises these effects: