How is the foreign currency rate converted between different countries?


Quick Answer

Foreign exchange markets electronically convert currency rates in response to global economic forces of supply and demand, inflation, consumer confidence and interest rates. These are known as floating exchange rates, and may change frequently depending on the balance of trade. However, some central banks support fixed exchange rates, which force currency to maintain a particular value in relation to another currency. For example, Great Britain's fixed exchange rate keeps the British pound sterling more or less equal to the euro.

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Full Answer

Many markets determine currency rates based on the value of a U.S. dollar. Some exceptions to this method include the currencies of Great Britain, Europe, Australia and New Zealand. Depending on the demand for the dollar, other currencies may be worth more or less in relation to it. Exchange rate indexes list one currency's value in relation to the collective values of foreign currencies. They rank currencies according to the amount and frequency of trade between countries.

Currency value may change due to high or low prices. For example, if one currency becomes expensive, foreign consumers seek out cheaper currencies. This causes the expensive currency to drop in price. If a country exports more than it imports, its currency gains value. During a trade deficit, a country's currency can drop in value.

A law known as the "one price law," or purchasing power parity, can also influence exchange rates. This law describes the price stability of some goods throughout the world. Price stability results from patterns of buying and selling that take advantage of price differences to realize a profit. It forces members of the global market to match the prices for certain goods to other currencies. This mechanism helps to maintain fair value in the global market.

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