Exchange Rates Explained: What Moves a Currency's Value

An exchange rate is just a price — the price of one currency in terms of another. But why that price moves, why some currencies are fixed and others float, and why the rate you see online is not the rate you actually pay are questions worth answering. This guide covers the forces behind currency values and how to read an exchange rate correctly.

1. What an exchange rate represents

An exchange rate is a relative price: how many units of one currency you get for one unit of another. In "1 USD = 0.92 EUR," the USD is the base currency and the EUR is the quote currency, so the rate is 0.92 euros per dollar. There is no such thing as a currency being "worth" a number in isolation — every rate is a pair, and the inverse (1 EUR = 1.087 USD) always multiplies back to 1.

rate(base → quote) = quote per 1 base
inverse            = 1 / rate(base → quote)

"The dollar strengthened" means the quote number fell (you need fewer euros to buy a dollar); "the dollar weakened" means it rose. Strengthen and weaken are always relative to which pair you are watching.

2. Floating versus fixed currencies

A floating currency's rate is set by the foreign-exchange market and moves constantly with supply and demand — the US dollar, euro, yen, pound, and Swiss franc all float. A fixed (pegged) currency is held at a set rate against another currency or a basket by its central bank, which buys and sells reserves to defend the peg. Many Gulf currencies peg to the dollar; some countries peg to the euro.

Most major currencies you will convert are floating, which is why their rates change every minute. Pegged currencies barely move against their anchor, so converting a pegged currency to its anchor gives an almost constant rate — but converting it to a third currency still fluctuates, because the anchor itself floats against the third currency.

3. What makes a currency rise or fall

Three forces dominate. First, interest rates: a country with higher rates attracts foreign investment (investors want the higher yield), which raises demand for its currency and lifts its value. Second, inflation: a country with higher relative inflation sees its currency's real purchasing power fall, so the nominal rate tends to weaken to restore parity. Third, the trade balance: a country importing more than it exports sells its currency to buy foreign goods, which tends to push the currency down.

Central-bank policy and market expectations amplify all three. If traders expect a rate hike, they buy the currency in anticipation, and the rate moves before the hike happens. This is why currency markets react to expected news, not just the news itself.

4. Real versus nominal exchange rates

The rate you see quoted is the nominal rate — the raw conversion number. The real exchange rate adjusts it for the different price levels between two countries, so it reflects what your money actually buys after conversion. If a dollar buys 0.92 euros but goods in the eurozone are 10% more expensive, the real rate is worse than the nominal rate suggests.

real rate ≈ nominal rate × (price level home / price level abroad)

This is why a strong currency does not always mean cheap imports: if the country you are visiting is expensive, a favorable nominal rate can still leave you paying more in real terms. The real rate is what matters for purchasing power.

5. Purchasing power parity

Purchasing power parity (PPP) is the theory that, in the long run, exchange rates move toward equalizing the price of identical goods across countries. If a Big Mac costs $5 in the US and £4 in the UK, PPP implies a fair rate of $1.25 per pound. The Economist's Big Mac Index is a famous (and tongue-in-cheek) check of PPP, comparing burger prices as a single standardized good.

PPP does not hold in the short run — currencies can stay far from parity for years because of interest-rate differences, capital flows, and trade frictions. But it is a useful benchmark for whether a currency looks over- or undervalued against another in the long run.

Try it yourself

The Currency Converter converts an amount between major world currencies using a static reference rate table, with cross-rates routed through USD. The Sales Tax Calculator and Tip Calculator handle the everyday percentage math that often accompanies a converted amount.