Money Education From RONIN Asset Management

How Exchange Rates Work
Maybe you’ve travelled to the U.S. or Canada, and exchanged your Aussie dollars for the Green back or Loonies. Or, perhaps you’ve traveled from England to Japan and exchanged your English pounds for yen. If so, you have experienced exchange rates in action. But, do any of us really know how they work?
You’ve probably heard the financial reporter on the nightly news say something like, “The dollar fell against the U.S. today.” In this article, we’ll attempt to explain what exchange rates are and some of the factors that can affect the value of currency in countries around the world.
The Cost of Money
National currencies are vitally important to the way modern economies operate. They allow us to consistently express the value of an item across borders of countries, oceans, and cultures. We need exchange rates because one nation’s currency is not always accepted in another. You can’t walk into a store in Japan and buy a loaf of bread with Aussie Dollars. First, you’d have to go to a bank and buy some Japanese yen with your Aussie Dollars. An exchange rate is simply the cost of one form of currency in another form of currency. In other words, if you exchange 1 Aussie Dollar for 86 Japanese yen, you really just purchased a different form of money.
The Floating Exchange Rate
There are two main systems used to determine a currency’s exchange rate: floating currency and pegged currency. The market determines a floating exchange rate. In other words, a currency is worth whatever buyers are willing to pay for it. This is determined by supply and demand, which is in turn driven by foreign investment, import/export ratios, inflation, and a host of other economic factors.
Generally, countries with mature, stable economic markets will use a floating system. Virtually every major nation uses this system, including Australia the U.S., Japan, Germany and Great Britain. Pegged rates are for economies trying to get themselves up to the international standards required for the free flow of money. They have their currency pegged for stability, China is in the news at the moment about this very thing. With countries like the U.S. saying that the Chinese are using their pegged rate as leverage and that they are now in a position to let their rate float. Floating exchange rates are considered more efficient, because the market will automatically correct the rate to reflect inflation and other economic forces.

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