Exchange rate: What does it mean?

Definition

An exchange rate refers to the value at which one currency can be exchanged for another.

What is an exchange rate?

An exchange rate is essentially the price of one country’s currency in terms of another country’s currency. Exchange rates are determined by the foreign exchange market, which operates globally and around the clock. These rates fluctuate constantly due to various factors such as supply and demand, economic indicators, geopolitical events, and central bank policies.

Exchange rates are quoted in pairs, with the base currency listed first and the counter currency listed second. The exchange rate indicates how much of the counter currency is needed to purchase one unit of the base currency.

There are two types of exchange rates: fixed and floating.

Fixed exchange rates: A currency’s value is tied to another currency or a basket of currencies. Governments or central banks maintain this fixed value by buying or selling their currency as needed. While providing stability, this system can be difficult to sustain in the long run.
Floating exchange rates: Currency value is set by market supply and demand. While central banks may intervene to stabilise or address extreme volatility, market participants primarily determine the exchange rate. This system offers flexibility and adapts more freely to economic changes.

Exchange rates play a crucial role in international trade, investment, and finance. They affect the cost of imported and exported goods and services, influence investment decisions, impact tourism and travel expenses, and can affect a country’s balance of payments and overall economic health.