What is Exchange Rate

The exchange rate is the rate at which one currency can be traded for another. Over the years, governments have adopted many different ways of managing exchange rates, including setting them by fiat and influencing them through central bank intervention. Today, most exchange rates in the developed world are freely floating, meaning that they are shaped by market forces and governments, by and large, stand back as passive observers of events. Occasionally, central banks will intervene to attempt to support a currency. They do this primarily by buying or selling it. All other things being equal, buying a currency causes it to rise in price, or appreciate in value relative to other currencies. Selling it causes it to depreciate in value.

Absent government intervention, the exchange rates between different currencies are caused by the size of trade and capital flows between the countries maintaining those currencies. Anything that affects the volume of those financial flows can ultimately affect the exchange rate. Exchange rates tend to be relatively stable over time but exhibit minor fluctuations on a day to day basis. Factors which can cause sharp rises or falls in the rate of exchange between one currency and another include dramatic news about the state of the economy or a rise or fall in interest rates which can provoke capital inflows or outflows respectively.