How Money Really Works, Part 6: How Exchange Rates Work

7. What does an exchange rate really tell you

An exchange counter's board shows what your money is worth abroad. Here are seven parts of how that price works. Number seven: what does an exchange rate really tell you? A central bank's explainer says an exchange rate is just a price.

The explainer adds that a currency getting stronger and its price rising in other currencies are the same thing said twice. The IMF calls that price the nominal exchange rate. Its own example says it costs 1.36 units of one currency to buy one unit of another. From the other side, the IMF says one unit of the first currency costs 0.735 units of the other.

A central bank's explainer says you are most likely to notice the exchange rate when you travel. The same explainer adds that when your currency is strong, you get more of the other currency for it. So the stronger your currency, the cheaper it is to buy things abroad, the explainer says. Fees and rules at each exchange counter differ where you live.

Someone or something has to set that price, and number six shows who. Subscribe for the next parts of this series: every source here is the IMF, the BIS or a central bank's own explainer, linked below.

6. Who sets your currency's price

Number six: who sets your currency's price, a central bank or the market? A central bank's explainer says that in some places the central bank sets the exchange rate, and in others it does not. The IMF says a country's exchange rate regime governs how much its currency is worth in other currencies. The IMF divides exchange rate regimes into three broad groups.

A hard peg means another currency is used by law. Or a law requires the central bank to keep foreign assets at least equal to local currency in circulation and bank reserves. With a hard peg, the IMF says the central bank has no independent monetary policy. Its interest rates are tied to those of the place behind the anchor currency.

A soft peg keeps a currency stable against an anchor currency or a mix of currencies. The band around that anchor is narrow at plus or minus 1%, or wide at up to plus or minus 30%. By our count, a narrow band of 1% either way keeps a rate of 100 between ninety-nine and 101. By our count, a wide band of 30% either way lets that rate move anywhere from seventy to 130.

In some soft pegs the peg moves over time, usually depending on differences in inflation between places. The IMF says a floating rate is mainly market determined. Central banks that float step in mostly to limit short-term swings, by buying or selling foreign currency. The IMF says floating regimes let a place keep an independent monetary policy.

Which kind of regime sets the price on your exchange counter's board depends on where you live. In a floating rate, demand moves the price, and number five shows what pulls that demand.

5. Why can an interest rate decision move your currency's price

Number five: why can an interest rate decision move your currency's price? You follow investors' money, which typically moves toward the currency that pays higher interest. A central bank's key interest rate can move the price of its own currency. A central bank's explainer says that where the market sets the rate, supply and demand decide it.

Many factors affect the demand for a currency in financial markets, and so its strength, the same explainer says. A currency gets stronger when more people want to buy it. The same explainer compares this to a train ticket that costs more at peak times. At those times, more people need to travel, so the ticket price rises.

Interest rates work the same way: higher ones lead investors to demand more of a currency. The explainer says that, typically, when a central bank raises its key interest rate, the currency gets stronger. The explainer adds that an economy seen as safe and sound draws more people who want to invest there. That also leads to a stronger currency, the explainer says.

An interest rate decision can reach the price of a holiday abroad. It can also reach the price tags on goods that come from elsewhere. That pull is typical, not certain, because many forces move a rate at once. Rates and rules differ where you live, so the pull on your currency can look different.

Investors buy and sell these currencies all day, and next comes the market where it happens.

4. Where does the rate on a counter's board come from

Number four: where does the rate on a counter's board come from? You step into the market where currencies change hands, around the clock. A central bank's explainer says market rates are the basis for the rates you get when you change money. The same explainer says investors all around the world trade huge sums of foreign currency every day.

It adds that, where the market sets the rate, it is these trades that determine it. The explainer also says these markets are a complex network of computers, not a physical market. So traders can buy and sell currencies twenty-four hours a day. Another central bank's explainer says the rate changes constantly on global markets where all kinds of currencies are traded.

The BIS says instruments called swaps and forwards are commonly used to hedge, or guard against, currency risk. Exchange counters and their fees follow local rules, and those rules differ where you live. That's four of the seven, and one idea makes the last three easier: a rate is only a price. Trading moves the price day to day; next comes a rate built from what goods cost in two places.

3. What does the same money buy in two places

Number three: what does the same money buy in two places? You compare the two, and that gives a parity rate. The IMF calls it the purchasing power parity rate, and it may well differ from the rate in financial markets. It is the rate at which the same amount of goods and services costs the same in each place.

The IMF's example uses a burger. It sells for two units in one place and four in another, so the parity rate is one to two. By our count, take a market rate of one to two and a half. The first place's burger then costs five units of the other currency, 25% more than four.

The IMF says parity rates are relatively stable over time, while market rates are more volatile. The IMF explains that if the same good is cheaper in one place, someone can buy it there and sell it in the other. That buying raises demand for the cheaper currency, which pushes the exchange rate to adjust. Costs like transport or trade barriers can get in the way of that adjustment.

The IMF says nontraded goods and services, like a haircut, tend to be cheaper in low-income places than in high-income places. The IMF says market rates are the logical choice for financial flows, the money moving between places. The parity rate is a yardstick for comparing prices. Counters quote their own rates, and the rules they follow differ where you live.

If you want the full picture on prices, the video on protecting your money from inflation is linked on screen. In one breath: a price read two ways, fixed or floating, what pulls money in, the market and the parity rate. Next, what a stronger or weaker currency does to the price tags in your own shopping.

2. What happens to a price tag on imported goods when your currency gets stronger or weaker

Number two: what happens to a price tag on imported goods when your currency gets stronger or weaker? When one unit of your currency buys more of another, products from that other place become less expensive, a central bank's explainer says. The same explainer says that, as a result, import prices fall. By our count, if your currency buys 10% more of another, goods priced there cost you about 9% less.

That same explainer says the change reaches inflation directly, through the prices of imported goods people buy. It also reaches inflation indirectly, through imported raw materials and parts used in production. A stronger currency makes those imported materials cheaper for the factory that buys them. Another central bank's explainer says a stronger currency makes exports more expensive for buyers abroad.

That can lead to lower sales for the exporters who ship those goods out. The IMF calls this the exchange rate channel: exports fall as they become more expensive, and imports rise as they become cheaper. A weaker currency works the other way, so goods from abroad cost more. That can show up in prices at home, on the shelf where imported goods sit.

A stronger currency means a foreign price tag converts into fewer units of yours. A weaker currency means the same foreign price tag converts into more units of yours. In general, a central bank's explainer says, people who buy more from abroad than they sell typically prefer a strong currency. And people who sell more abroad than they buy typically prefer a weak one.

How far a rate change reaches shop prices also depends on where you live and the rules there. Price tags are only half the story, so here is a question before number one. At the same exchange rate, how much more do you think the same good can cost?

1. How much does your money really buy abroad

Number one: how much does your money really buy abroad? Two shop shelves can show the same exchange rate and carry very different price tags. The nominal rate alone does not show that difference, but the real rate does. The IMF calls it the real exchange rate, and it measures the value of one place's goods against another's.

The IMF gives an example: the nominal rate is 1.36. A good costs 2.5 units in one place and 3.4 units in the other. That gives a real rate of one, which means parity for that good. The IMF's example continues: the first price is three units instead of 2.5.

Now the real rate is 1.2, so at the same exchange rate that good costs 20% more abroad. By our count, at a real rate of 1.2, 100 units of yours buy abroad about what eighty-three buy at home. The nominal rate counts the units you get, while the real rate shows what those units buy. A real rate is measured for a basket of goods, not for every purchase, and rules differ where you live.

And that is what your money really buys abroad, not just how many units. So, seven parts: a price read two ways, who sets it, and what pulls money in. Then the market that never sleeps, prices in two places, price tags at home and what your money really buys. Today, you can open the IMF's real exchange rate explainer, linked below, and follow its example yourself.

Which of the seven changed how you see a price abroad? Tell us the number in the comments. Results vary, rules differ where you live, and this is information only, not financial advice. This is Wealth Filings.

If you want to see part seven, subscribe now: it follows one payment from the tap of a card to money sent abroad. Next on Wealth Filings, How Money Really Works, part seven: what happens when you pay.