Exchange rates determine how much of one currency you can buy with another currency. Different countries have different kinds of money. Major world currencies include the dollar in the United States, the euro in the European Union, the pound sterling in Great Britain and the yen in Japan. Exchange rates change constantly as they react to market forces.
There are two types of exchange rates. The first is a free floating exchange rate that changes in response to market forces. If more people want currency "A" than currency "B," currency "A" will have a more favorable exchange rate. One unit of currency "A" will buy more of currency "B" than before when the exchange rate was not as favorable. Some countries protect their currencies by artificially "pegging" their exchange rate to another currency. The government sets their exchange rate at a specific level relative to a strong currency. For example, China used to peg their currency, the yuan, to the U.S. dollar.
There are pros and cons to both types of exchange rates. A free floating exchange rate works well when currencies are strong. When a country's economy is in crisis, its exchange rate can plummet relative to other currencies. A weak currency makes a country's exports cheaper but its imports more expensive. If the country relies heavily on imports, a free floating exchange rate makes an economic crisis even worse. A pegged exchange rate artificially makes a currency strong against other currencies. This helps countries that export a lot of goods, since they are paid more for their products. However, this can encourage trading partners to turn to protectionism and tax the exporting country's goods to compensate. Pegged currencies also encourage a black market exchange rate. Illegal currency trading occurs at rates more in line with market forces. This undermines the government's attempt to protect its currency.
A country's currency with a strong exchange rate with the rest of the world is considered "hard" currency. The United States dollar, the European Union euro, the British pound sterling and the Japanese yen are considered hard currencies. Many people living in countries with "soft" currencies prefer to perform transactions in hard currencies since they to hold their value better. Many soft currencies fall victim to hyperinflation and are often devalued. A fortune in soft currency can become worthless. If your money is in hard currency your cash is more likely to hold its value.
Travelers to other countries must understand how exchange rates function. When obtaining foreign currency the exchange rate determines how much of it you can buy with your home currency. When your home currency is strong against the foreign currency, it is cheap to travel there. When it is weak, travel is expensive. If you go to a bank or currency exchange business to convert your money, the exchange rate will always be lower than the rate quoted in currency markets. This is a fee for the bank or business converting your money. When you use a credit card or ATM card in a foreign country, your bank back home uses the currency market exchange rate for that day minus a fee to determine how much is deducted from your account.
Exchange rates fluctuate daily and they also follow longer cycles that last decades. Some currencies that were once strong have lost their power around the world while once weak currencies are now sought after. The once mighty dollar lost much of its influence around the world during the home mortgage crisis of 2008. The pound sterling was devastated after World War II but recovered to become one of the major hard currencies of the world.
