Exchange rate — Definition Explained Simply | Examples & Role
Official exchange rate is the price of one currency expressed in units of another currency, i.e. the ratio of exchange between the monetary units of different countries.
Exchange rate is the ratio between the monetary units of different countries, showing how many units of one currency can be exchanged for one unit of another. In other words, it is the “price of a currency” on the international market. The rate is influenced by the purchasing power of currencies, the balance of payments, the level of inflation, and capital flows between countries.
The exchange rate plays a crucial role in international trade and finance: it determines export competitiveness, the cost of imports, the profitability of investments, and debt obligations. According to the European Central Bank, exchange rates are used daily by banks, companies, and individuals for millions of transactions worldwide.
Formation of exchange rates
Exchange rates can be established in two ways:
- Market rate — determined by supply and demand in the currency market (typical for a floating regime).
- Official rate — set by the government or central bank and may be supported through interventions.
Main types of exchange rates
- Official exchange rate — fixed by the government for the national currency. If it differs from the market rate, the central bank must support it through interventions.
- Floating exchange rate — freely fluctuates under the influence of market forces. Most major world currencies (such as the US dollar, euro, and yen) have a floating rate. In case of sharp fluctuations, the central bank may intervene.
- Forward exchange rate — the rate at which a currency can be bought or sold today for delivery in the future. It is often used for hedging risks.
How the exchange rate differs from a quotation
The concepts of exchange rate and currency quotation are closely related but not identical. The exchange rate is the actual ratio between two currencies (e.g. 1 EUR = 1.10 USD). A currency quotation is the way this rate is presented on the market, i.e. the record showing how many units of one currency correspond to one unit of another. Thus, the exchange rate is an economic measure, while the quotation is its expression in trading and banking practice.
The role of the exchange rate in the economy
The exchange rate determines how affordable a country’s goods and services are for foreign buyers. A stronger national currency makes imports cheaper but exports more expensive for foreigners. A weaker currency stimulates exports but raises the cost of imports. This is why governments closely monitor exchange rate fluctuations and regulate them when necessary.
Examples
- EUR/USD = 1.10 means that 1 euro equals 1.10 US dollars.
- In Russia, the official ruble-to-dollar rate is set daily by the Bank of Russia.
- A forward contract may provide for the purchase of USD 1 million in three months at a rate of 1 USD = 95 RUB.