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How Exchange Rates Work

        Money | Currency

Hybrids

In reality, few exchange rate systems are 100 percent floating, or 100 percent pegged. Countries using a pegged rate can avoid market panics and inflationary disasters by using a floating peg. They peg their rate to the U.S. dollar, and that rate doesn't fluctuate from day to day. However, the government periodically reviews their peg, and makes minor adjustments to keep it in line with the true market value.

Floating systems aren't really left to the mercy of market forces, either. Governments using floating exchange rates make changes to their national economic policy that can affect exchange rates, directly or indirectly. Tax cuts, changes to the national interest rate, and import tariffs can all change the value of a nation's currency, even though the value technically floats.

The next time you cross a border, and trade your money for that of another country, remember that economic forces across the world helped determine that exchange rate. In fact, when you exchange currencies, you're one of those economic forces -- you're helping to set the exchange rate, too.

Although this system works pretty well most of the time, it's not always the best solution.


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