To understand the currency exchange, you must first understand the history. For hundreds of years, the different currencies of the world have been backed by gold. Meaning, paper currency throughout history has been represented by an actual gold amount held in a secure location by the government which issued it.
The United States in the 1930s set the value of the US dollar at a level that was unchanging. Every $35 US Dollars represented one ounce of gold. This made it easier for any other form of currency to be valued against the dollar because they could base it on its value in gold. So, a currency worth three times as much gold as the USD (US Dollar) was therefor worth three times as much as the US Dollar. This didn't last very long, as eventually the economics of the real world moved faster than this system could keep up.
Currency Exchange - What is it?
Today, the U.S. dollar is still atop most financial markets, but, it is no longer represented by an actual amount of gold or any other precious substance. The US Dollar is now controlled by the market.´The two main systems for determining exchange rates are the floating currency system and pegged currency system.
In floating exchange, the market determines the rates. Which basically means, a currency is worth what the market is willing to pay. This is simple supply and demand, pushed by things like, import and export ratios, inflation, and several other economy related factors. The major nations of the world use this system, due to having much more stable economic markets. Floating exchange rates are more widely used because they're considered to be the most efficient, as they rely on the market to correct the rates when dealing with inflation and other economic changes.
The pegged system is a fixed rate system which is maintained by the government. It doesn't fluctuate as it is directly pegged to some other countries currency. (Usually the USD) Economies with the risk of becoming unstable, or immature economies usually use this type of system. Developing countries use this system in an effort to protect themselves against wildly out of control inflation. The pegged system can easily back fire as black markets may tend to spring up to exchange currency at its market value, ignoring the government's set rate.
People realizing their currency isn't worth as much as the government says tend to flood the market exchanging their currency with others. This drives the money exchange rate dangerously low. Which can render a countries currency worthless.
Very few currency exchange systems are completely floating or pegged. In most cases there is a form of hybrid, this is called the floating peg. This method isn't perfect either, but it does work pretty well most of the time.