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The Basics of Currency Exchange
Every country has its own official currency, such as the US Dollar (USD), the Euro (EUR), the British Pound (GBP), or the Japanese Yen (JPY). These currencies are not fixed in value against each other. Instead, their value is determined by foreign exchange (Forex or FX) markets, where currencies are traded daily.
When you convert one currency into another, you’re essentially buying one currency and selling another. The exchange rate tells you how much of the target currency you’ll get for your source currency. For example, if the exchange rate from USD to EUR is 0.85, it means that 1 US dollar equals 0.85 euros.
What Determines Exchange Rates?
Exchange rates fluctuate constantly due to a variety of economic, political, and market factors. These are the main drivers:
Supply and Demand: Like any other market, currency values are influenced by the basic forces of supply and demand. If many people want to buy a certain currency (high demand), its value will go up. Conversely, if there’s low demand, the value may fall.
Interest Rates: Central banks (like the Federal Reserve or European Central Bank) set interest rates to control inflation and stabilize the economy. Higher interest rates tend to attract foreign investment, increasing demand for the currency and boosting its value.
Inflation: Countries with low inflation typically see a rise in their currency’s value over time. High inflation devalues currency and can result in a lower exchange rate.
Political Stability and Economic Performance: Investors prefer stable countries with strong economic fundamentals. Political turmoil or economic downturns can lead to decreased investor confidence and currency depreciation.
Trade Balances: A country with a trade surplus (exporting more than it imports) usually has a stronger currency, because foreign buyers must purchase its currency to pay for the goods. A trade deficit can weaken a currency.