The exchange rate is what you need to be concerned with whenever you need to buy something from another country which does not accept the same currency as the one in your country. This is obviously even more important if you travel to another country.

It is essentially the price of one type of paper money (or electronic money, as it may be) in another type of paper money.

Exchange rates are commonly quoted in newspapers, financial magazines, at money changers and in banks.

There usually is a quoted bid-ask spread (or buy-sell spread) when you ask for an exchange rate. The difference between these two prices is the profit that the money changer you are dealing with makes when making the exchange for you.

As alex.tan says, an exchange rate is the price of one currency in terms of another. And like all prices in a free market the exchange rate can be explained by supply and demand.

The main determinate of exchange rate is actually the interest rate. If the British interest rate rises, then there will be a flow of hot money into the country by international speculators. This is an increase in demand in Sterling and therefore leads to the price of the Pound rising in terms of others - an appreciation (or strengthening) of the Pound. Equally, if the interest rate falls there will be a fall in demand, depreciating the currency.

The main implication of a change in exchange rates is that the prices of exports and imports change. If the Pound were to strengthen, then it would cost more Euros per Pound. Therefore, if the price of a good were to stay the same (in monetary terms) in the UK it would cost more in Euros, raising the relative price of UK exports. Likewise, a Pound would buy more Euros, making imports into Britain cheaper for the British. This will result in British industry becoming less competative in all markets.

Something to be wary of when examining exchange rates.

Britain and America have different systems for showing exchange rates. In Britain, the value of a currency is measured in terms of the number of units of another currency it buys. In America, the value of a currency is the number of units it takes to buy a single unit of another currency. So in America, a strong currency is represented by a small number, whilst in Britain it is shown by a big number.

So say the exchange rate is £1 to $2. In the US, the value of the dollar (the number of dollars it takes to buy a pound) is 2, and that of the pound (the number of pounds it takes to buy a dollar) is 0.5. In the UK however, the value of the pound (the number of dollars it can buy) is 2 and the value of the dollar (the number of pounds it can buy) is 0.5.

In one sense, it does not matter which method you use, they are both accurate. However, the American system can potentially be very confusing. When the dollar strengthens, the number representing the strength of the dollar goes down, which feels somewhat counter-intuitive. That is why, if you pick up a copy of the Wall Street Journal, you will find that the numbering on the Y-Axis of graphs showing changes in exchange rates are often upside down, big number at the bottom, small number at the top, so when a currency strengthens, the line goes up instead of down.

Before you start analysing exchange rates, make sure you know what country you're in.

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