Factors which influence the exchange rate
An exchange rate is determined by supply and demand factors. These are the various factors which determine the demand and supply of a currency.
1. Inflation
If inflation in the UK is lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for £s. Also foreign goods will be less competitive and so UK citizens will supply less £s to buy foreign goods.
Therefore the rate of £ will tend to increase.
2. Interest Rates
If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK, Therefore demand for Sterling will rise. This is known as “hot money flows” and is an important short run determinant of the value of a currency.
3. Speculation
If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise.
Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets.
For example, if markets see news which makes an interest rate increase more likely, the value of the Pound will probably rise in anticipation.
4. Change in competitiveness
If British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound.
5. Relative strength of other currencies
Between 1999 and 2001 the £ appreciated because the Euro was seen as a weak currency.
6. Balance of Payments
A large deficit on the current account means that the value of imports is greater than the value of exports. If this is financed by a suplus on the financial / capital account then this is OK. But a country who struggles to attract enough capital inflows will see a depreciation in the currency. (For example current account deficit in US of 7% of GDP was one reason for depreciation of dollar in 2006-07)
Essays and Revision Notes on Exchange Rates
- Exchange Rates revision notes and essays
- Factors influencing exchange rates
- Determination of exchange rates in free markets
- Effects of Appreciation
- Effects of Depreciation
- Government Int
- Fixed Exchange Rates
- International Trade Revision Notes
- Globalisation Essays
Exchange Rate Essays
- Effects of a falling Dollar
- Why Dollar keeps falling
- Discuss Policies to Stop the Dollar Falling
- Does Devaluation Cause Inflation?
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