- The exchange rate is the rate at which one currency trades against another on the foreign exchange market
- If the present exchange rate is £1=$1.42 this means that to go to America you would get $142 for £100. Similarly if an American came to the UK he would have to pay $142 to get £100. Although in real life, the dealer would make a profit.
- Currencies are being continuously traded on the foreign exchange markets, with the prices constantly changing as dealers adjust to changes in supply and demand
- Currencies will also undergo long term changes depending on the state of the comparative countries. E.G. in the 1920s the £ was worth $4.50
- Exchange rate index This gives a measure of a currency against a trade weighted basket of currencies. It is expressed as an index, where the value of the index will be 100 in the base year.
- The weight given to each currency depends upon the proportion of transactions done with the country. For example in the Sterling exchange rate index the highest weighting will be given to the Euro and then the dollar.
- Real Exchange Rate. This is the exchange rate after being adjusted for the effects of inflation, it therefore more accurately reflects purchasing power
- Floating exchange rate – When the value of the currency is determined by market forces – supply and demand for currency
- Fixed exchange rate – where the government seeks to keep the value of a currency at a certain level compared to other currencies. See: Fixed Exchange Rates
Determination of exchange rates using supply and demand diagram
In this example, a rise in demand for Pound Sterling has led to an increase in the value of the £ to $ – from £1 = $1.50 to £1 = $1.70
Factors influencing exchange rates
- Interest rates – higher interest rates encourage hot money flows and demand for currency. This causes an appreciation.
- Inflation – higher inflation makes exports less competitive and reduces demand for currency. This causes a depreciation.
- Confidence in the economy / currency.
- More detail: factors influencing exchange rates
Appreciation of exchange rate
If the Pound Sterling appreciates in value, the effects will include:
- UK exports more expensive abroad – leading to lower demand.
- Imports into the UK will be cheaper, increasing demand for imports
- An appreciation will tend to reduce inflation, but also lead to lower economic growth.
- More detail: effects of appreciation
Depreciation / Devaluation
If the Pound devalues then we will see:
- UK exports become more competitive, increasing demand for exports
- Imports become more expensive, leading to lower demand for imports
- A depreciation will tend to increase economic growth, but also cause inflation.
- Does a devaluation help an economy?
More pages on exchange rates
- Understanding exchange rates
- Effects of a falling Dollar
- Why Dollar keeps falling
- Discuss Policies to Stop the Dollar Falling
- Does Devaluation Cause Inflation?
- Definition of depreciation and devaluation