How are currency exchange rates calculated?

[Vesayen]

Inspired by the thread about our good buddy, Senior Chavez.

A few minutes of internet research yielded nothing useful. Then it occured to me: I can always ask apolyton!

So how the heck ARE exchange rates calculated? I know it is somehow vaguley connected to overall economic wellbeing of a country and perhaps something to do with it's GDP and national debt, but that is not what I wanted to know.

How are exchange rates on currencies decided and what effects them, day to day?

[snoopy369]

For floating currencies, they are bought and sold at market like stocks, give or take, either individually or more commonly as "baskets" of currencies ("SE asian currencies", ie).

Currencies can also be "pegged" to another currency, for example the Bolivar is "fixed" at 2.15/$ or whatever the other thread mentioned. From my understanding, that usually means that the Venezuelan National Bank will give you $1 for every B2.15 you hand them, guaranteed regardless of the real exchange rate. In some cases this works this way; in some cases it's a theory that is not so effective in practice (ie, they won't really give you that amount).

Pre-WWII, many currencies were pegged to the Pound; this played a significant role in the Great Depression, because when a few Pound-pegged currencies were hit, it affected all of the Pound Sterling pegged currencies.

[snoopy369]

http://en.wikipedia.org/wiki/Exchange_rate

That article explains some of why a currency will fluctuate... ultimately it's supply + demand, where supply is determined by:
1. Money supply (how many real or digital $$ are in circulation, both from the government and from banks who are lending more than they have on hand)
2. Savings rate (how much money is saved in banks and such as opposed to spent) versus loan rate (how much of above saved money is invested versus kept on hand)
And demand is determined by:
1. Stability/growth of economy/currency. This does not necessarily mean "safe economy", it's referring to the currency; future gains (or lack thereof) is just as interesting as current performance (or more!).
2. Commodities markets. If the commodities market is doing poorly, people will convert 'gold' into 'cash'; it is likely that "safe" currencies will benefit from this (as commodities such as gold are generally investments for risk-averse investors).
3. Economic policy of the government. A higher interest rate encourages holding of that currency, so if the US interest rate rose a few points, the dollar might strengthen.
4. GDP and unemployment. These are not only measures of the economic strength of the country, but also affect demand on currency; more frequent spending of currency increases the demand for currency (reduces the amount in banks and such).
5. Political uncertainty. Again a part of stability, but a special case. Areas where the politics is ... interesting, currency will typically be valued less. Venezuela is a good example of this; investors are hesitant to invest there, because not only is it a country with frequent coups in the recent history, but Chavez has nationalized things before, and so is a risk to do so again, with currency.

That's an incomplete summary of the topic, and it's based on my 10 years ago classes, so take that just as a basic idea... DanS and others can undoubtedly shed more light on the subject and correct my undoubtedly many errors