- 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
Value of the Pound to Dollar 2006-2016. In mid-2008, there was a sharp depreciation in the value of the Pound because the UK was hit very hard by the credit crunch. The Pound also dropped after the Brexit vote in June 2016 because markets were less optimistic about the long-term fortunes of the UK economy outside the EU.
- 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 the purchasing power of a currency.
- 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.
- Economic growth – higher economic growth will tend to cause an appreciation in the currency, this is because markets expect higher interest rates – when growth is rapid.
- Inflation – higher inflation makes exports less competitive and reduces demand for currency. This causes a depreciation.
- Confidence in the economy/currency.
- Current account deficit/surplus. A large current account deficit is more likely to cause a depreciation in the value of the currency because money is leaving the economy to buy imports.
- See more detail at 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,
- Lower economic growth – due to reduced demand for exports.
- Worsening of the current account deficit (because imports are cheaper and quantity of imports rises, but exports are more expensive and quantity falls)
- Strong Pound = Imports Cheaper, Exports Dearer. SPICED
- 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?
Evaluation of exchange rates
Elasticity of demand. If there is a depreciation in the exchange rate, exports are cheaper, but the amount quantity increases depend on the elasticity of demand. If demand is price inelastic, then a depreciation will have a limited impact in increasing demand and improving economic growth. If demand for exports is elastic, then there will be a big boost to exports.
Time Lag. In the short term, demand for exports is often inelastic but becomes more price elastic over time.
Reasons for depreciation/appreciation. Often it is most successful economies who see appreciation. The currency appreciates because there is more demand for their exports. Therefore, in this case, a depreciation won’t cause a fall in economic growth – only limit the growth rate. If the currency appreciates due to speculation, during a period of weak economic growth, then the negative effect on growth may be more pronounced.