An exchange rate is the rate at which one currency is traded for another.
For example if 1 Pound Sterling buys 1.5 US Dollars, then the exchange rate is £1 to $1.5.
Why exchange currencies?
Currency is exchanged, or traded, continuously around the world. Currency is traded for a variety of reasons:
For going abroad:
Needing foreign money to go on holiday is perhaps are first experience of exchange rates. You will take your home countries currency to a bank or money changer and exchange it for the currency used wherever you are going on holiday. This then allows you to buy goods and services while on holiday.
For importing and exporting:
Many firms trade internationally and will therefore need to use a variety of currencies. For example if I am a British fashion designer selling my clothes in the USA and Europe I don’t want to get paid in US Dollars or Euros. I can’t spend Euros or Dollars on the UK high street, try buying shopping in Tesco with Dollars and see what happens. Therefore I will ask to be paid in Pounds and my customers will transfer money from their US bank accounts to my British bank account, selling $ and buying £.
So at the £1 to $1.5 exchange rate to buy £1000 worth of clothes the American customer will need to exchange $1500 into £.
International trade such as this is extremely important to exchange rates.
Firms may also wish to invest in a foreign country.
Let’s say my fashion firm is doing really well and I want to set up a studio in the New York as well as London. I will need to invest in the office space, equipment etc. This will require me to exchange £ for $, again this because the person selling the studio is unlikely to accept £.
Obviously this is small scale but when Toyota decides to invest in multi-billion pound factory the effect on the exchange rate can be quite pronounced.
Likewise, if you want to invest in the shares of new American company to buy those share you would need to exchange £ for $.
Another important factor affecting the exchange rate is currency speculation. Investment banks or individuals may buy and sell currency in expectation of future changes in the exchange rate.
For example if people expect a currency to go up in value they may buy it now to sell later at the higher price.
Some of this may be very rapid. Investment banks may exchange vast amounts of money very quickly to take advantage of small fluctuations in the exchange rate. By contrast a firm or individual may keep some money in a foreign currency because they expect currency to appreciate in the longer term or as insurance against a fall in the value of their own currency.
Small currencies can be seriously affected by speculation. And even large currencies such as the £ are not immune.
Government and central banks may also buy and sell currency in an attempt to shift the value of currencies to meet a particular economic target. For example, if a government believes the strength of its currency is limiting its ability to export it may use its foreign currency reserves to weaken its own currency or increase the value of its major trade partners.
For example, China buying assets valued in US Dollars and therefore increasing the demand of the US Dollar and thus increasing its value. As a result this will make it easier for American consumers to buy Chinese goods and therefore increase Chinese exports.
(Just a quick warning on the above point, my students seem to get obsessed with the idea that governments are continuously intervening in currency markets. This is not really the case. Governments may want to intervene in the currency markets but they will be fighting the forces of the market and this is very unlikely to be successful, it can also be extremely expensive and have other unforeseen negative impacts on other macroeconomic goals.)
If you have any questions on the above please do leave it as a comment below.