International exchange rates display how much one currency can be exchange for another. These exchange rates can be floating, where their value can fluctuate depending on a variety of factors. They can also be pegged or fixed to another currency, where they move alongside the currency on which they are pegged.
Floating vs. Fixed Exchange Rates
One can determine the currency prices in two ways: floating rate or a fixed rate.
A Floating Rate
A floating rate is determined by the open market through supply and demand via the global currency markets. Thus, if the demand for the currency is high, its value will increase. And if the demand is low, this will drive the currency price lower.
Several technical and fundamental factors will play into what the markets perceive is the fair exchange rate and alter their supply and demand accordingly.
A Fixed Rate
Meanwhile, a fixed or pegged currency rate is determined by the government through the central bank. The rate is set against another major world currency, like the US dollar, the euro, or yen.
To maintain the exchange rate, the government will buy and sell its own currency against the currency to which it has been pegged. Among the countries that peg their currencies to the greenback are the US dollar and Saudi Arabia.
Factors that Affect Exchange Rates
As we have mentioned, floating rates are determined by the forces of supply and demand. For instance, if the demand for the US dollar by the Europeans go high, the supply and demand relationship will show an increase in the price of the US dollar relative to the euro.
There are also numerous geopolitical and economic announcements that influence the exchange rates between two nations. A few of those include the interest rate changes, unemployment rate, inflation data, gross domestic products, manufacturing report, and commodities.
The short-term moves in a floating currency exchange rate regime reflect the rumors, speculations, disasters, and daily supply and demand dynamics for the currency.
Extreme short-term moves can compel the country’s central bank to intervene even in a floating environment. As such, although major global currencies are considered to be floating, central banks and governments may step in if the country’s currency becomes too high or too low.
A currency that is too high or too low could influence the nation’s economy adversely. It would also affect trade and the ability to pay debts. The government or central bank will also attempt to implement measures to move their currency to a better price.
More macroeconomic factors impact exchange rates. According to the law of one price, the price of a good in one country should be equal to its price in another. This is called the purchasing price parity, or PPP.
If the price gets out of range, the interest rates in a country will also move. Of course, what happens in the real world doesn’t always follow economic theories because of various interfering factors.