What Determines a Currency's Exchange Rate?

Like any other price in local economies, exchange rates are determined by supply and demand — specifically the supply and demand for each currency. But that explanation is almost tautological as one must also know we need to know what determines the supply of a currency and the demand for a currency.

• The supply of a currency on a foreign exchange market is determined by the following:
• Demand for goods, services, and investments priced in that currency.
• Speculations on future demands of that currency.
• Central banks occasionally buy up foreign currency to affect the exchange rate.

There is at least a rough level to which a currency should be worth, as detailed in the Purchasing Power Parity Theory. The exchange rate, in the long run, needs to be at the level which a basket of goods costs the same in two currencies. Thus, if a Mickey Mantle rookie card, for instance, costs $50,000 Canadian and $25,000 U.S., the exchange rate should be two Canadian dollars for one American dollar.

The exchange rate is actually determined by a variety of factors, which change constantly. As a result, it's important when traveling abroad to check the current exchange rate in destination countries, especially during peak tourist season when the foreign demand for domestic goods is higher.