How Exchange Rates Work

The Euro

On January 1, 2002, the euro became the single currency of 12 member states of the European Union -- making it the second largest currency in the world (the U.S. dollar being the largest). This was, to date, the largest currency event in the history of the world; sixteen national currencies have since completely disappeared and were replaced by the euro. (For even more information on the euro, check out How the Euro Works.)

The original seed for a common currency was planted in 1946 when Winston Churchill suggested the creation of the "United States of Europe." His goals were primarily political, in that he hoped a unified government would bring about peace for a continent that had been torn apart by two world wars.

Although the euro is fundamentally a tool to enhance political solidarity, it also has the economic effect of unifying the economies of participating countries. Some of the euro's advantages, in regard to economics, include:

  • Elimination of exchange-rate fluctuations - The euro eliminates the fluctuations of currency values across certain borders.  
  • Transaction costs - Tourists and others who cross several borders during the course of a trip had to exchange their money as they entered each new country. The costs of all of these exchanges added up significantly. With the euro, no exchanges are necessary within the Euroland countries.  
  • Increased trade across borders - The price transparency, elimination of exchange-rate fluctuations, and the elimination of exchange-transaction costs all contribute to an increase in trade across borders of all the Euroland countries.  
  • Increased cross-border employment - With a single currency, it is less cumbersome for people to cross into the next country to work, because their salary is paid in the same currency they use in their own country.

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