Today’s Wonder of the Day was inspired by Dinesh Kumar from Ranchi, Jharkhand. Dinesh Kumar Wonders, “How does the exchange rate of currency between one country to another is derived?” Thanks for WONDERing with us, Dinesh Kumar!
If you do plan to travel to another country, one thing you'll probably need to do is exchange some of your money for whatever currency is used in the country you plan to visit. For example, Americans traveling abroad might have to exchange U.S. dollars for euros, yen, or pesos.
It would be convenient if one U.S. dollar was equivalent to one euro, one yen, and one peso, but that's not the case. Each country has its own currency, and each country's currency is valued differently.
When you exchange your money for another type of currency, you're basically buying another country's money. How much of that country's money you're able to buy with one U.S. dollar depends upon the exchange rate.
This practice was known as the gold standard, and it controlled international exchange rates until the early 20th century. Eventually, though, supplies of gold weren't sufficient to meet the demand for currency.
In the early 1970s, the U.S. moved completely away from the gold standard. This meant that the value of the dollar would be controlled by market forces, and the international monetary system would be based on the dollar and other paper currencies.
The U.S. dollar dominates many world financial markets today. Many exchange rates are expressed in terms of U.S. dollars. The U.S. dollar and the euro make up about half of all currency exchange transactions across the world.
There are two primary systems that determine a currency's exchange rate. Most major countries with established, stable economic markets use a floating exchange rate. For example, the United States, Canada, and Great Britain all use floating exchange rates.
Floating exchange rates are determined by the market based upon supply and demand. Many factors can affect a floating exchange rate. Some of the major factors include inflation, interest rates, unemployment rates, foreign investment, and trade ratios.
Smaller or developing countries with economies that might be unstable from time to time tend to use a pegged or fixed exchange rate. Pegged exchange rates are set and artificially maintained by the government. The term "pegged" refers to the fact that rates are pegged to another country's currency, often the U.S. dollar.
Pegged exchange rates don't fluctuate from day to day. Governments must make continual adjustments to keep their pegged rate stable. This means they must keep large reserves of foreign currency to accommodate fluctuations in supply and demand.