What determines exchange rates?
You will have heard the term “exchange rate”, and you probably have knowledge of what it means. But, if you’re someone who transfers money internationally you’ll want to have a complete understanding.
Why? It will help your money go further for you and your loved ones. So, here we list everything you need to know about exchange rates, including:
- What do we mean by “exchange rate”?
- Floating and fixed rates
- Is there a relationship between the demand for foreign exchange and the exchange rate?
- Who decides the exchange rates?
- What factors affect exchange rates, and how?
- Is a higher or lower exchange rate better?
In short, the exchange rate is how much the currency of one country is worth compared to the currency of a different country or economic zone.
Let’s look at a simple example:
If you were living in the UK and you wanted to send money to Nigeria, what would this mean? Well, on 24 February, the exchange rate was 1 GBP to 540.63 NGN. This means that you would be able to buy 540.63 NGN with every one of your British pounds.
As well as being a direct way of buying and selling currency for those who are travelling or sending money overseas, the exchange rate is also used as a way of measuring a country’s economic health [Investopedia]. A country that has a higher-valued currency means that their imports are cheaper and exports are more expensive for other countries to buy.
This means they make more profit when trading internationally.
Most nations have floating (or flexible) exchange rates that change on a minute-by-minute basis.
The majority of exchange rates are determined by the foreign exchange market, or “forex”, which particularly impacts the currencies most used by people in the US (such as: Mexican pesos, Canadian dollars, European euros, British pounds, and Japanese yen). [The Balance] More on the factors that affect these exchange rates a little later on.
The government of some countries, like Venezuela, choose to use fixed exchange rates. These only change when the government says so and are often “pegged to the US dollar”. This means that their worth is directly linked to the dollar.
Countries that are pegged to the dollar:
Countries that are pegged to the Euro
However, in this article we will focus on floating exchange rates.
For countries that use a floating exchange rate, the value of their rate depends on a variety of factors. It’s often assumed that exchange rates are fixed by banks, but this isn’t the case.
While the Bank of England is the UK’s central bank, it does not decide how much the pound is worth against other currencies [Bank of England]. Worth noting that the Bank of England can impact exchange rates by:
- Adjusting an important interest rate called the Bank Rate (if Bank Rate goes up, the pound is seen to be more valuable)
- Limiting inflation (keeping prices reasonable)
So, if it’s not The Bank of England, who does decide how much the pound is worth?
As the Bank of England explains: “The exchange rate for the pound is decided by supply and demand, just as the price of a train journey is higher at peak times when more people need to travel, the pound gets stronger when people want to buy more pounds.”
Investors and “foreign exchange traders” all around the world buy and sell foreign currency every day. This happens all day every day and in 2019 around $6.6 trillion was being traded on a daily basis [The Balance].
It’s these trades — based on what traders are willing to pay for different currencies that day — that decide the global exchange rates for the pound. Banks and money transfer companies, like us, use these rates to decide how much our customers can buy and sell currencies for.
So, how much a country’s currency is worth is based mainly around the demand for that currency. In turn the demand for a currency depends on what’s happening in that country at any given time.
- Interest rates: The higher interest rate makes that currency more valuable. Investors will exchange their currency for the higher-paying one. They then save it in that country's bank to receive the higher interest rate
- Money supply: If the government prints too much currency, then there's too much of it chasing too few goods. Currency holders will bid up the prices of goods and services. That creates inflation. If way too much money is printed, it causes hyperinflation
- Financial stability: If the country has a strong, growing economy, then investors will buy its goods and services. They'll need more of its currency to do so. If the financial stability looks bad, they will be less willing to invest in that country. They want to be sure they will get paid back if they hold government bonds in that currency
- Speculation: If traders believe that the value of the pound will rise, they will demand more in order to make a profit, and this demand will increase the value of the pound
The strength of other currencies, how competitive British goods are, foreign investments, import/export ratios, government debt and a host of other economic factors can affect how much the pound is worth too [How Stuff Works].
If you’re sending money abroad from the UK, you are using the pound to buy another currency. You are looking for a higher exchange rate. This way, you’ll get more of the foreign currency you’re buying [Foreign Currency Direct]. Let’s use Pakistan as an example:
You want to send £1,000 home to Pakistan.
The exchange rate on February 3rd, 2021 was 1 GBP = 218.43 PKR.
Using this exchange rate you would be able to buy 218,420 PKR with £1,000.
Just 20 days later, on February 23rd, 2021, the exchange rate was 1 GBP = 224.30 PKR
Using this exchange rate you would be able to buy 224,300 PKR with £1,000.
As you can see, a higher exchange rate is better, because it means your recipient will get more rupees for the same amount of your pounds.
The great thing about using Small World for your money transfer, is that we adjust our exchange rates. We keep a close eye on changes in the global market to make sure we give you the best value for your money. We compare rates, so you don’t have to.
Register with Small World in just a few simple steps and start sending money today.