What is an exchange rate?

We often see it on television: the exchange rate of the Euro against the Dollar has fallen, or vice versa of course. We live in a world with a very complex economic system, of which the currency market, and therefore exchange rates, play a large part. What exactly is an exchange rate?

What is an exchange rate?

The exchange rate is the price of one currency expressed in another currency.

Example:

The exchange rate of the Euro is 1.55 against the Dollar. This means that for 1 Euro you get 1.55 Dollars. For 1 Dollar you get 1 / 1.55 = 0.64 Euro.

What types of exchange rates are there?

There are different types of exchange rates:

  • Floating exchange rate : The exchange rate is completely free to change, and governments do not intervene.
  • Fixed exchange rate : The exchange rate is supervised by governments, which fix the exchange rate according to their own wishes.

In practice, the majority of exchange rates are floating rates. China has a fixed exchange rate to keep the country’s exports as high as possible.

How is an exchange rate determined?

An exchange rate is determined by supply and demand for certain currencies:

  • When there is a high demand for a currency, the exchange rate will rise (appreciation).
  • When there is a large supply of a currency, the exchange rate will fall (depreciation).

The Netherlands is an export country. This means that the Netherlands exports more than it imports. The Netherlands, like other export countries, is therefore highly dependent on the exchange rate of its own currency, in our case the Euro. Importing countries, usually African countries, import more than they export. This results in the exchange rate of the country’s currency falling, as there is little demand (little exports), but a lot of supply (many imports).

Example:

The exchange rate of the Euro is 1.20 against the Dollar. Americans then pay for a product that costs 1000 Euro: 1000 * 1.20 = 1200 Dollars. We pay for a product that costs 1000 dollars: 1 / 1.20 = 0.83 euros per dollar = 1000 * 0.83 = 830 euros. So it is relatively “expensive” for Americans to buy products from the Netherlands, and relatively cheap for us to buy products from the United States. Dutch imports will then increase, while exports will decrease. Due to decreasing demand, the Euro exchange rate will fall, and eventually there will be more demand again: rates will recover themselves.

How can action be taken?

Governments can intervene in various ways to “manipulate” the exchange rate. In the European Union (EU), the European Central Bank (ECB) monitors the Euro rate: it strives for stability of the Euro and intervenes if necessary. The ECB can use the “interest rate weapon”, raising or lowering interest rates in the EU:

  • Increasing interest rates : The demand for a currency increases, because investors want the highest possible interest rate.
  • Cutting interest rates : Demand for a currency falls as investors move away.

In the past, buying and selling large amounts of currency was also possible, but nowadays there is so much money in circulation that it would take billions to see any change.