How Exchange Rates Work
An exchange rate is simply a price. Just like the price of apples at a store changes based on supply and demand, currency prices change the same way. When many people want to buy euros but few people are selling them, the euro's price goes up. When many people are selling dollars but few want to buy them, the dollar's price goes down. Banks and currency traders constantly buy and sell currencies in markets around the world, and their actions determine what the exchange rates are at any moment.
What Causes Exchange Rates to Change
Exchange rates change because of many different factors. If a country's economy is strong and growing, more people want that country's currency, so its value increases. Interest rates set by central banks also matter: higher interest rates make a currency more attractive because people can earn more money by saving in that currency. Political events, wars, natural disasters, and news about a country can also affect whether people want that currency. Even rumors about economic changes can cause rates to shift quickly.
The Global Currency Market
Currencies are traded in a massive worldwide market called the foreign exchange market, or forex. This market operates 24 hours a day, 5 days a week across different cities like London, Tokyo, and New York. Trillions of dollars worth of currency trades happen every single day. Major players include banks, investment companies, governments, and currency traders. Unlike a stock market that has one physical location, forex is mostly electronic and spread across the entire globe.
Fixed vs. Floating Rates
Most countries today use floating exchange rates, which means rates change freely based on market activity. However, some countries peg or fix their currency's value to another currency or to gold. For example, a country might decide that their currency will always equal a specific amount of US dollars. Fixed rates are more stable but give governments less economic flexibility. Most economists prefer floating rates because they adjust naturally to economic conditions.
Why Exchange Rates Matter
Exchange rates affect everyday life in important ways. When you travel to another country, you need to exchange your money at the current rate. Businesses that buy or sell products internationally depend on exchange rates to figure out their costs and profits. If exchange rates change dramatically, it can make imported goods more expensive or less expensive in stores. Investors also watch exchange rates carefully because changes can affect how much money they make on international investments. 
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