Ever wonder how trade flourished before money was introduced? Goods were exchanged for goods in what we know as the barter system! How did it work? To put it in simple terms, people exchanged goods of which they had an excess supply (more than their needs) for goods which they didn’t have or had insufficient supplies. For example, if A had an excess of vegetables and B had an excess of corn, they could exchange vegetables for corn and agree on what quantity of vegetables or corn would be a fair exchange for the other.
When money was introduced, the same logic was applied, except it was now how much money for a specified quantity of a good. With multiple currencies coming into play, this logic came to be called what we all know as monetary exchange rates. To reiterate, the value at which a single unit of one currency can be traded or exchanged for a similar unit of another currency is termed as the exchange rate. Read on to find out how monetary exchange rates can be calculated.
The process for calculating exchange rates is quite simple, the way it works is explained below:
- Two currencies are considered, depending on how the calculation is being worked, one currency is tagged as the base currency. For example, you want to calculate the exchange rate between US dollars and British pounds. If you want to know how much 1 US dollar will fetch in terms of pounds, then the base currency is the dollar and vice versa.
- Continuing with the same example, one US dollar equals 0.5 British pounds; i.e. you can buy half a pound with one US dollar.
The formula used to calculate monetary exchange rates is as follows:
Dollar - pound rates or pound – dollar rates, where the currency listed first is the base currency and always has a value of one.
1 US dollar = ‘x’ British pounds or 1 British pound = ‘y’ US dollars, the formula is:
Dollar rate = 1/0.5 (assumed exchange rate) = $2 (one pound will by 2 US dollars).
Setting of exchange rates between currencies
Monetary exchange rates are set on the basis of the economic performance and ‘balance of trade’ between two countries, whose exchange rate is to be calculated. Balance of trade between 2 countries can be a positive or negative sum, depending upon the total value of exports and imports. For example, if ‘A’ exports $100 worth of goods and imports $50 worth from ‘B’, the balance of trade is positive in A’s favor by $50 or negative in B’s favor by the same amount.
Another factor to be considered while calculating an exchange rate is the supply and demand for a particular currency. If supply exceeds demand, the currency rate drops and vice versa. Other factors which determine the exchange rate are interest rates and inflation.
Types of exchange rates
There are mainly two types of exchange rates – fixed or floating/variable – which determine the value of one currency with respect to another. A fixed rate is set by the central monetary authority in a country. The local currency is pegged at a specific percentage of any major world currency, usually US dollars or the Euro in today’s market.
A floating rate is calculated based on market forces, such as supply and demand, inflation, etc as explained previously.
The logic and system behind setting up an exchange rate between two currencies is beyond the scope of this article, however, the information pertaining to using an exchange rate to calculating the relative values of two currencies, as explained in the first half of the article, should suffice in helping you calculate monetary exchange rates.