What Are Exchange Rates?

What are exchange rates? Simply, exchange rates are the relationship between two currencies, or how much of one currency can you buy with another. You may have heard that currencies can be strong or weak. Now, the strength of a currency is simply determined by the age-old laws of supply and demand. A currency becomes stronger relative to other currencies when the demand for that currency outweighs supply. Now, there are a lot There are a lot of explanations as to why a currency becomes stronger relative to others. The first is the inflow of what's called hot money, speculative flows of foreign money to take advantage of high interest rates in the host country. The second is an increase in demand for host country's products and services, where foreign currency is exchanged into the local currency in order to buy things. And finally, there might simply be an increase in foreign investment into a country, further increasing the demand for the host currency. So how then do we know whether a country's currency is over or undervalued relative to other currencies? This can be confusing as currency pairs tend to have very different historic exchange rates, and it's frustrating that fair value for each currency pair is not simply 1:1. Therefore, we use a concept called purchasing power, or how many units of your currency do you need to buy, say, a Big Mac in another country? Let's give an example. Let's say you are waiting in Heathrow for a flight bound to New York. You decide to buy a Big Mac in the terminal for £4. At the time, you think to yourself that you might be peckish when you land at JFK, so you make sure that you have £4 worth of dollars for another Big Mac on landing. However, when you get to the front of the queue and try to buy a Big Mac with your £4 worth of dollars, you find that you can only buy 3/4 of the Big Mac. In this example, it's very likely that the pound is undervalued relative to the dollar. Now, is it a good thing to have a strong currency? Well, to an extent, yes, as it is a fair reflection that your country is in rude health, as demand for domestic goods, services, and investments are high, and also your currency strength means that imports become cheaper. However, a strong local currency can harm a country's exports as they become uncompetitive in a global market. Both strong and weak currencies have benefits and drawbacks. It is a wise politician that seeks to benefit in both scenarios.