Exchange Rate

What Is Exchange Rate?

An exchange rate is the price of one currency expressed in terms of another, for example how many euros one U.S. dollar can buy. Exchange rates come in two broad types. A floating exchange rate is determined by supply and demand in foreign exchange markets, rising and falling freely as those forces change. A pegged, or fixed, exchange rate is one that a government or central bank holds at a set value against another currency or a basket of currencies, intervening to keep it there. Many countries use intermediate arrangements, letting their currency float within managed limits. Exchange rates are among the most important prices in the global economy.

Why It Matters

Exchange rates connect a country's economy to the rest of the world by setting the relative price of its goods, services, and assets. On the AP Macroeconomics foreign exchange graph, when foreign buyers increase their demand for a country's goods, demand for its currency shifts right and the currency appreciates. Movements in the rate ripple through trade: a stronger currency makes imports cheaper and exports dearer, while a weaker one does the reverse. Interest rates matter too, since higher domestic rates tend to attract investors seeking returns, raising demand for the currency. Whether a country chooses a floating or fixed regime shapes how it absorbs economic shocks and how much independence its central bank has over monetary policy.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• What is a "floating" exchange rate?
  One determined by supply and demand in foreign exchange markets
• What is a "pegged" (fixed) exchange rate?
  One a government or central bank holds at a set value against another currency or basket of currencies
• What is the core idea of purchasing power parity (PPP)?
  Exchange rates should tend to adjust so that an identical basket of goods costs the same across countries