How Exchange Rates are Determined

There are a few variables that contribute to determining how exchange rates are determined. Foreign currency exchange rates that constantly fluctuate are exchange rates for floating currency. This means that the value of a specific currency, such as the U.S. dollar, is not controlled by government interference. The value of the U.S. dollar rises and falls with the economic laws of supply and demand. Some countries, such as Belize, have a fixed currency exchange rate. For example, one U.S. dollar is equivalent to two Belizean dollars, and that exchange rate does not fluctuate.

Purchasing Power Parity

To the easiest way to understand the complex way in which exchange rates are determined is to think in terms of purchasing power parity, or PPP. The PPP economic theory means that identical goods in different countries have the same price if prices are set in the same currency. For example, a gallon of milk costs $2 in the U.S. and costs 1 Euro in Germany. The PPP is that $2 is worth 1 Euro and $1 is worth 50 European cents.

Supply and Demand

The value of currency is determined on the daily supply and demand of a currency. If demand for a currency is high, but the supply of that currency is low, the price of that currency increases. If demand for a currency is low, but the currency supply is high, the currency price decreases. There are many reasons why demand for a specific currency increases or decreases, including the need for currency conversions for transaction purposes. For example, if a U.S. citizen or company wants to purchase goods in France, then the U.S. individual or business must convert U.S. dollars into Euros, which creates a demand for Euros.  Demand for a currency also can increase or decrease because of speculation. This means investors buy or sell currencies based upon economic predictions that the price of that currency will increase or decrease.