Strong dollar, weak pound, strengthening euro! What does it all mean? A simple guide to exchange rates.

As of writing this article, one dollar is equal to 0.9 euros. 0.9 euros is equal to 0.76 pounds. In China, 0.76 pounds will get you 6.54 Yuan. If you exchanged this 6.54 Yuan for Vietnamese dong you would get over 22,000! The question is simple: why??

Before explaining how these exchange rates are calculated, let’s first talk about what an exchange rate is… Countries around the world all have their own type of money, the correct term for this is ‘currency’. For example, in the USA they use the dollar ($) in Japan they use the Yen (¥) and in the UK they use the pound sterling (£). The exchange rate is simply the value of one currency in terms of another.

In the modern global economy, exchange rates can change, meaning the value of a currency can either become stronger (appreciate) or weaker (depreciate) in relation to another currency. If you are only buying goods and services in your own economy this wouldn’t be a problem, however the world is not closed for business, it is very much open for business! Goods and services are bought and sold between countries every day and therefore the exchange rate helps determine how much currency needs to be exchanged for the transaction to take place.

How does the exchange rate change by itself though? This is where the magic of free market economics happens. Just like in the market for any good or service, the price of a currency is determined by the interaction of supply and demand. In the case of money, if demand for a currency increases, this leads to an increase in its value. As a result, the exchange rate would appreciate. The opposite is therefore also true: if demand for a currency decreases, this leads to a decrease in its value. As a result, the exchange rate would depreciate.

In the global economy, we often hear about currencies being strong and weak. Interestingly though, the weaker your currency is, the more competitive it is. How does that work? Well, imagine that a company in the USA wanted to buy microchips from a company in China. Let’s say that the cost is 10 Yuan per unit. At today’s exchange rate, where 1 Yuan is equal to 0.14 USD, the cost per unit for the American company would be 1.44 USD (0.14 X 10). Now imagine that the Yuan got weaker, and the exchange rate is now 1 Yuan for 0.1 USD. The price for one microchip is now 1 USD. After the depreciation of the Yuan, Chinese products are now cheaper for overseas buyers, making their exports (goods and services sold to other countries) cheaper and thus more competitive! That’s great for Chinese exporters then but not so great for companies who rely on imports (goods and services bought from other countries) as they are now more expensive!