Currency exchange rates affect everything from the cost of imported goods to the returns on international investments. This guide covers the basics of how rates are quoted and what drives them.
How currency pairs are quoted
A currency pair like EUR/USD shows how much of the second currency (USD) it takes to buy one unit of the first (EUR). If EUR/USD is 1.10, one euro buys $1.10. The first currency is the base; the second is the quote currency.
What moves exchange rates
| Factor | How it works |
|---|---|
| Interest rate differentials | Higher rates tend to attract capital, supporting a currency |
| Economic growth | Stronger growth prospects can attract investment flows |
| Inflation | Persistently higher inflation tends to weaken a currency over time |
| Trade balances | Countries that export more than they import see more natural demand for their currency |
| Risk sentiment | In times of stress, capital often flows toward perceived safe-haven currencies like the US dollar |
Why the dollar reacts to Fed policy
Because the US dollar is the world’s primary reserve currency, Fed interest-rate decisions have an outsized effect on global currency markets, not just the US economy. Rate hikes tend to support the dollar; rate cuts tend to weaken it, all else being equal.
Key takeaways
- A currency pair quote shows how much of the quote currency it takes to buy one unit of the base currency.
- Interest rate differentials, growth, inflation and trade balances all influence exchange rates.
- Fed policy has an outsized global effect given the dollar’s role as the world’s primary reserve currency.
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