Exchange rates are set by supply and demand on the open market. The world’s governments would most likely love to have the opportunity to sit down and set exchange rates collaboratively, but that is not how the global currency market works. Instead, governments can impact exchange rates only indirectly.
Managing Exchange Rates
If a currency becomes under-valued or over-valued, the government has limited options for how to affect the exchange rate. In fact, sometimes they use the same kind of money exchange process as a normal investor to manipulate exchange rates, flooding the market with currency reserves to change the supply and demand balance for their own currency.
One other option is to either increase interest rates throughout the entire banking system, reducing the supply of money and making the local currency stronger compared to other currencies, or to decrease the interest rate, having the opposite effect.
Another option is quantitative easing. This means, essentially, printing more money, increasing the supply of the currency and weakening it in terms of the exchange rate. This is not a popular option because it can have a knock-on effect on exchange rates and it can be difficult to balance. Instead of doing this, the government may sell treasury notes — essentially borrowing money from other countries. This increases the supply of currency and also increases the country’s debt temporarily, weakening the local currency.
Why Exchange Rates Matter
Exchange rates matter because they affect the kinds of businesses that are attracted to a country, and they affect the price of goods too. If a currency is too strong, then this will have a negative effect on exports because goods will be too expensive to buy. If the currency is too weak, then companies may not have the purchasing power to import goods. A strong currency means cheap imports and lower inflation, as well as a lower cost of living for individuals.
Inflation will lower the value of your cash in real terms, but a weak local currency can be a good thing because it helps exports, strengthens the economy and can help to create jobs. In the short term, your money will not go as far, but in the long term if the exchange rate goes back down or inflation falls, then you could end up better off. If you invest, whether that is in stocks and shares or currency, then movements in exchange rates will have an impact on the value of your investments.
Most people don’t worry about exchange rates unless they are planning on changing money to go on holiday, but it is worth paying attention to what is going on in the broader economy. We live in a global economy, and currencies do not exist in isolation. A huge amount of the products we use on a daily basis are imported from other parts of the world, so fluctuations in exchange rates can have a bigger impact on your lifestyle than you might first expect.