# How is exchange rate calculated?

assume that there is a very new island-country called xland. they decide to name their currency xdollar and there is 1000 xdollars in circulation. the very first foreigner comes and wants to exchange his us dollar to xdollar. how is the rate calculated? is it purely supply-demand? conversely, can the xland's bank tell him "oh you are the only one who demands some xdollars, so let's give you a crappy rate of 100 usd for 1 xdollar"?. how is xdollar's very first rate against all other currencies set?

p.s: sorry if the question is not well formed or is stupid.

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There are no stupid questions. – ripper234 Mar 24 '11 at 12:50
@ripper: there are stupid question. This is not one, though. – o0'. Apr 9 '11 at 13:48

The question is hypothetical.

In the real world, things don't happen this way. The currencies and exchange rates have evolved over a period of time. These rates were initially pegged to Gold Reserves (as most countries had Gold to back currencies), which subsequently got changed to US Dollar reserve, and today is mostly market determined based on demand and supply.

So in a real sense, if there is a new piece of land that is not explored/inhabited, the first colonizers would use the currency of their origin. For example, Greenland--which is today part of Denmark--is following the Danish Krone. If sometime in future, they become a separate country, they would have an equivalent Danish Krone and other reserves. When the new currency gets created, they would peg the value of this against other currencies. Typically, the transition to the new currency would be staged, and during the first stage it would be directly in line to the Danish Krone with a fixed rate. You'd use this as the basis for deriving the rate for other currencies, and over a period of time, it will become free market linked.

So essentially in your case, if the Xland is self sufficient [does not import or export anything from/to the external world] then there would not be any exchange rate, as the self-supporting Xlanders would have no value for the USD that you are giving them--what would they do with it? Now, if they are buying something from the outside world and need to pay in USD, any they don't have any USD, they would have to sell something they produce to generate the USD. In an ideal situation, the value of goods imported compared to the value of goods exported would determine the exchange rate. However, in the real world, there would be various other considerations; for example, if Xland wanted to store more USD reserves to purchase something in the future. Some of these considerations may be reflected in the exchange rate, some may not.

Once trade is established, it determines how the country Government and Central Bank are regulating the rate. If the rate is fixed, then the government is giving a guarantee. Depending on how much trust Xland has with others, they may pursue trade at that rate, or they may not. Therefore, it can't be very off from reality. If it is off, then they have other ways to nudge other countries to accept the fixed rates. China, for example, follows a fixed rate.

In a managed float, the central bank would intervene if the fluctuations are large. In floating, it would be a pure function of supply and demand, which is directly linked to current trades and future trades.

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Not hypothetical, but rather happening right now. See my answer. – ripper234 Mar 24 '11 at 12:50
In the context asked, I still feel its hypothetical. Any currency essentially is a system to enable exchange for goods or services. To that extent the concept of money is non existant. Bitcoin is trying to create an alternate system which is fine. But the approach to creating new money [pumping money] is radical and in my opinion not workable. The creation should have been more on goods delivered. to the person who delivers has a Promise to receive and the person who gets has promise to pay. – Dheer Mar 24 '11 at 13:00
Can someone explain the downvote? – Dheer Jul 1 '11 at 7:19

It's funny, but this is exactly what is happening right now with bitcoin - it's not a theoretical discussion. It is a startup currency, whose value is determined solely by supply and demand. Check out the exchange rates.

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I don't think this answers the question of "how is xdollar's very first rate against all other currencies set?", but rather cites an example. Maybe this should be a comment? – Alex B Mar 24 '11 at 19:41
I think that it provides a case study. I'll leave it as an answer, perhaps it's not the best of answers though... – ripper234 Mar 25 '11 at 2:12
On an exchange where the maximum amount of trading is \$400 (yes, without a B, M or even a K after it) I'm not sure that is really useful information. – DJClayworth Mar 25 '11 at 17:17
@DJClayworth - wait a year. The growth rate is exponential. – ripper234 Mar 27 '11 at 22:08

Exchange rates are basically calculated according to what Wikipedia calls Competitor Indexing

So the first ever xland foreigner comes along and wants to buy xdollars. The first xdollar market maker will first of all take a guess at a quote, say, for 5 USD at which he will sell an xdollar. Maybe the foreigner says yes. Or maybe there is no market. We wait for a while. Say there's no market. So the market maker, who has lots of xdollars and wants to make a few more, says, ok 4 USD. At this point the foreigner says `mine` and buys an xdollar for 4 USD. Now the `market` has an offer price.

So what does the market maker know? He knows there is someone to whom he can sell xdollar at 4. So based on the first deal, he can make xdollars if he can buy them for less than 4. So he himself goes to another xlander and says: hey dude, will you give me an xdollar for 3 USD. And the other xlander says `yours` and sells him an xdollar for 3 USD. Now the `market` has a bid price.

Having two deals under his belt the market maker has the same number of xdollars, and one US dollar more. So he goes looking for some more xland foreigners :-)

The market for xdollar is 3 USD at 4 USD because the market maker will buy for 3 and sell for 4.

But who knows where the xland market will go. Other xlanders seeing the excitement from their first ever market maker decide to join in the game. So there we are, it depends on supply and demand, and we are back to Competitor Indexing

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