By Fergus Cleaver
Currency exchange rates are in the news a lot these days. Back in June 2016, when the United Kingdom voted to leave the European Union, the value of the British pound plunged against other world currencies, including the U.S. dollar and Japanese yen. People holding assets valued in pounds, or holding cash accounts denominated in pounds, collectively lost billions overnight.
How and why did that happen? The answer lies in the complex cause-and-effect relationships between the political, economic and even cultural forces shaping the global economy, and the subjective and objective public perceptions of the sovereign governments underwriting them.
Most people don’t know much about the ins and outs of currency exchange rates, nor do they understand how exchange rates fluctuations affect their daily lives. The good news is that a basic understanding of the relationship between global currencies, and the forces that make them tick, does not require an advanced economics degree. Here’s what you need to know—no fluff, just the facts.
Fiat vs. Gold Standard
Historically, sovereign currencies’ values were tied to the price of gold. For instance, back in the day, the value of the U.S. dollar was fixed at $35 per ounce of gold.
This arrangement suffered from systemic drawbacks. After manually adjusting the dollar-gold ratio, the U.S. government eventually abandoned the gold standard altogether. The replacement is known as fiat currency—basically, a dollar is worth whatever the government says it is.
Economic Strength and Weakness
Currency values serve as rough proxies for faith in the economic and political stability of their backers. For instance, the value of the euro declined precipitously (grew weaker) during the early 2010s, when it appeared that the European Union was in danger of collapse. The value of the U.S. dollar, whose backing government appeared more stable, rose (grew stronger) during that time.
Exchange Rate Effects
Exchange rates don’t just reflect the state of the broader economy—they can also affect it, both directly and indirectly. When a currency is stronger, its home country’s exports tend to cost more in international markets. When a currency is weaker, its home country’s exports usually cost less. Counterintuitively, then, a weak currency can actually be good for export-driven economies.
How to Calculate an Exchange Rate
Simple. Use an exchange rate calculator.
Though they rarely fluctuate wildly in one direction or another, exchange rates are quite dynamic. They’re living, breathing simulacra of the broader economy. If you’re curious about the precise value of a particular currency on any given day, use an exchange rate calculator or check popular currency pairs with a reputable financial resource, like CNBC. (Yes, CNBC is reputable, if you ignore all the breathless headlines.)
The answer to the inevitable next question: Yes, you can make money on the currency markets. The same basic rule of trading applies to currency markets, just as it applies to equity markets: Buy low, sell high.
The foreign exchange market is often known as forex. It’s a complex and fraught landscape, one that you shouldn’t dive into without professional guidance. Suffice to say that thousands of gutsy professionals earn very good livings on the forex market. With the proper training and mindset, perhaps you can too.