All About Exchange Rates And What They Mean

If you have ever been on holiday abroad you will know what exchange rates are all about, and how confusing they can be.  If the country you are visiting doesn't share the same currency as your own country, you will need to exchange your own money for the currency used at your destination.

Some currencies are more familiar to us than others, so if you are a Briton going on holiday to America you will know that you'll be spending dollars while you are away.  But if you go on holiday to Brazil, China, Estonia or Bulgaria, to name just a few, would you be so sure of what you'd be spending during your break?

Exchange rates can be difficult to get to grips with, but there are plenty of online websites that can help to clarify matters for you.  The currencies themselves are usually easy to understand, since most world currencies now work according to the decimal system.  So if you go to China for example, even though you may not be familiar with the Renminbi (their currency of choice) you will be familiar with the concept that it is split into a hundred parts.

The problem comes in working out whether a loaf of bread, for example, costs the same in this country as it does when you are on holiday in another country.  To work this out you will need to find out what the rate of exchange is between the two countries.

At the moment for example one British pound will get you around two US Dollars, but of course the exchange rate will vary from day to day – and even minute to minute.  This can affect how good your holiday is if there was to be a sudden drop in the exchange rate.  If you changed up your money now you would get two hundred dollars for every hundred pounds, but if the value of the dollar slumped tomorrow and it was worth only one dollar fifty against the pound, your spending money wouldn't go anywhere near as far – even though the value of the goods you would be buying would be the same.

Exchange rates are quite complicated to understand, but they are tied to the economy and rate of inflation of a country.  Even the general mood of the population and the feeling among expert commentators on monetary situations can influence the exchange rate, since a currency can be valued at far less at the end of a day due to certain situations that occur in the world of business and politics than it was at the beginning of the day.  This in turn affects what that country can buy from other countries, since its own currency will not be worth as much outside of its borders as it was just hours earlier.

Even from this very basic illustration it's possible to see that the exchange rates between different countries can greatly affect what goes on inside those countries.  But there is even more at stake than this.

The problems really start when the exchange rates between two countries are continually at odds with each other.  This is what's known as currency misalignment.  In very basic terms this means that the value of a specific currency is not as it should be.  So for example, a loaf of bread in America might cost, let's say a dollar.  Now if you exchanged some of your dollars for the currency of another country, you might find you have to spend the equivalent of four dollars to get that same loaf of bread in that country.

The reason for currency misalignment isn't always the same in every case.  Sometimes it can simply happen that a particular currency becomes the victim of rampant inflation and effectively becomes worthless.  In the past this kind of situation has led to currencies being ditched in favour of starting all over again with a new version of that same currency.  It is an extreme measure, but it has happened in situations where people have had to pay something in the region of thousands or millions of units of their currency for simple everyday items.

It has also been noticed that the governments of certain countries have generated currency misalignment to benefit their own needs and advance their goals.  This kind of situation is much harder to rectify, because although the process of introducing a whole new currency is a radical one, the government in that situation is eager to do it.  It is protecting its own interests in the second situation, which means that they won't want to realign their currency with those in other areas of the world.

It's clear that there is no easy answer in these situations.  Thankfully however most of the countries in the world are pretty much in balance with each other, and while the exchange rates will naturally ebb and flow and change on a daily basis, we don't tend to see huge differences in the values of specific currencies.

Of course there are situations where new currencies are introduced – such as the Euro several years ago – and the exchange rate has to be decided very carefully before the new currency actually comes into being.  Once that initial exchange rate is decided however, anything can happen, as it was seen in the case of the Euro when it plummeted against most other major currencies virtually overnight before re-establishing itself.

For countries which adopt a new currency on the date of its inception it can be an unnerving experience.  There is no real way of knowing whether the exchange rate which has been decided upon is the right one, and how well it will stand up when the figures no longer exist in theory, but for real instead.

So the next time you go onto a currency site and work out the exchange rate for two specific currencies, think about everything that goes into the figure you get back.  It's really a sobering thought, isn't it?