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How are currency exchange rates set? MintGenie explains

A fruit vendor counts a wad of Indian Rupee currency notes for payment at his roadside stall in Mumbai on July 19, 2022. - The Indian rupee fell to more than 80 per US dollar for the first time on record on July 19, as the greenback extended its rally and foreign capital outflows intensified. (Photo by INDRANIL MUKHERJEE / AFP) (AFP)Premium
A fruit vendor counts a wad of Indian Rupee currency notes for payment at his roadside stall in Mumbai on July 19, 2022. - The Indian rupee fell to more than 80 per US dollar for the first time on record on July 19, as the greenback extended its rally and foreign capital outflows intensified. (Photo by INDRANIL MUKHERJEE / AFP) (AFP)

  • Value of a nation’s currency plays a key role in its bargaining power in global trade. Most countries want their currencies optimally priced so that they can extract the maximum out of their exports, and pay the least for imports.

Currency exchange rates of prominent countries drive international trade and commerce. When a country’s currency rate rises in the forex market, its imports tend to get cheaper, and when the exchange rate of its national currency falls, the imports get pricier. So, it’s vital to have a strong and stable currency to make the most of its goods in international trade. The currency exchange rates are set in two different ways: fixed rate and floating exchange rate.

Fixed exchange rates are the ones that are set in relation to another currency by the nation’s government via its central bank. The countries that determine their own currencies against the US dollar include Saudi Arabia and China. On the other hand, a floating exchange rate is the currency that is decided by macro factors, its demand and supply in the open market.

READ MORE: How do fluctuating currency exchange rates impact your investments?

Demand and Supply

In alignment with the traditional economic fundamentals, the exchange rate rises with demand, and declines with it. For instance, when there is a heightened demand of British Pound Sterling (GBP) among US traders and merchants, then the price of pounds in relation to US dollars (USD) is likely to increase, but of course — this will be subject to a range of other geopolitical factors also.

However, even in floating rate also, the countries often intervene to influence their currency to make it suit to their advantage. Besides, there are scores of other factors in international trade, currency markets and the overall global economy that influence the currency exchange rates.

READ MORE: What is a currency pair and how does it work?

Other factors

There are a slew of factors that collectively influence the exchange rate of one currency in relation to another. These include inflation, GDP data, changes in interest rate and unemployment. There are a range of short-term factors that influence the exchange rate such as daily demand and supply, natural or economic disasters and at times – rumours. For instance, when the supply races past the currency’s demand, the exchange rate will crash, and when the demand exceeds its supply, the exchange rate will jump.

And in case of substantial slide or jump, the central bank tends to intervene and either buys or sells the currency to curb volatility.

Other key factors that impact the currency’s exchange rate include stability of government and geopolitical risks – that speak about the consistency of stable governance in the country and the world around it, impacting international trade and also the currencies that drive it.

So, the exchange rates of currencies are determined by a number of factors that include demand & supply, macroeconomic factors, geo-political stability, interest rates, GDP data, among other reasons.

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