What is currency exchange?


Currency exchange, or forex, is the conversion of the currency of one country into another. In a free economy, a country’s currency is valued according to the laws of supply and demand. In other words, the value of a currency can be pegged to the currency of another country, such as the US dollar, or even to a basket of currencies. The value of a country’s currency can also be set by the country’s government.

However, many countries freely float their currencies against those of other countries, which keeps them in constant fluctuation.

Factors that affect the value of the currency

The value of any particular currency is determined by market forces based on trade, investment, tourism, and geopolitical risk. Every time a tourist visits a country, for example, he must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of his country of origin for the local currency. Currency exchange of this type is one of the demand factors for a particular currency.

Key takeaways

  • Currency exchange, also known as forex, is the conversion of the currency of one country into another.
  • The value of any particular currency is determined by market forces related to trade, investment, tourism, and geopolitical risk.
  • Currency exchange is handled globally between banks and all transactions are under the auspices of the Bank for International Settlements (BIS).

Another important demand factor occurs when a foreign company seeks to do business with another in a specific country. Usually, the foreign company will have to pay in the currency of the local company. At other times, it may be desirable for an investor from one country to invest in another, and that investment should also be made in the local currency. All of these requirements create the need for foreign exchange and contribute to the enormous size of the foreign exchange markets.

Currency exchange is handled globally between banks and all transactions are under the auspices of the Bank for International Settlements (BIS).

How inflation affects exchange rates

Inflation can have a significant effect on the value of a country’s currency and its exchange rates with other currencies. While it is just one factor among many, inflation is more likely to have a significant negative effect on the value of a currency and the exchange rate. A very low inflation rate does not guarantee a favorable exchange rate, but an extremely high inflation rate is very likely to have a negative impact.

Inflation is also closely related to interest rates, which can influence exchange rates. The interrelationship between interest rates and inflation is complex and often difficult to manage for currency-issuing countries. Low interest rates stimulate consumer spending and economic growth, and generally positively influence the value of the currency. If consumer spending increases and demand grows beyond supply, inflation can occur, which is not necessarily a bad result. However, low interest rates do not usually attract foreign investment like higher interest rates do. Higher interest rates attract foreign investment, which is likely to increase demand for a country’s currency.

www.investopedia.com

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Mark Holland

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