- The exchange rate is the rate at which one currency is exchanged with another in the currency market.
- If the current exchange rate is £ 1 = $ 1.42, this means that to go to the US you would get $ 142 for £ 100. Likewise, if an American arrives in the UK, he should pay $ 142 to get £ 100 . Although in real life, the retailer would make a profit.
- Currencies are continuously traded in currency markets, with prices constantly changing as distributors adjust to changes in supply and demand
- Currencies will also undergo long-term changes depending on the status of the comparative countries. EG in the 1920s the £ was worth $ 4.50
Value of the pound in 2006-2016 dollars. In mid-2008, the value of the pound depreciated sharply because the UK was heavily hit by the credit crisis. The pound also fell after the Brexit vote in June 2016 because the markets were less optimistic about the long-term fortune of the British economy outside the EU.
- Exchange rate index Provides 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 attributed to each currency depends on the percentage of transactions made with the country. For example, in the sterling exchange rate the highest weighting will be given to the euro and therefore to the dollar.
- Real exchange rate This is the exchange rate after being adjusted for the effects of inflation, so it more accurately reflects the purchasing power of a currency.
- Floating exchange rate: when the value of the currency is determined by market forces: currency offer and demand
- Fixed exchange rate: in which the government tries to maintain 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
Factors influencing exchange rates
- Interest rates: higher interest rates encourage cash flows and demand for foreign currency. This causes an appreciation.
- Economic growth: greater economic growth will tend to make the currency appreciate, this because the markets expect higher interest rates, when growth is rapid.
- Inflation: higher inflation makes exports less competitive and reduces the demand for foreign currency. This causes depreciation.
- Trust in the economy / currency.
- Current account deficit / surplus. A large current account deficit is more likely to cause the currency value to depreciate because money is leaving the economy to buy imports.
Appreciation of exchange rate
If the pound is appreciated in value, the effects will include:
- UK exports are more expensive abroad, which leads 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 lower export demand.
- Worsening of the current account deficit (as imports are cheaper and the quantity of imports increases, but exports are more expensive and the amount decreases)
- Strong pound = cheaper imports, more expensive exports. PICADO
Depreciation / Devaluation
If the pound is devalued, we will see:
- UK exports become more competitive, increasing export demand
- Imports become more expensive, resulting in reduced import demand
- Depreciation will tend to increase economic growth but it will also cause inflation.
Evaluation of the exchange rate
Elasticity of demand. In the event of a depreciation of the exchange rate, exports are cheaper, but the amount increases according to the elasticity of demand. If demand is not elastic to prices, depreciation will have a limited impact on the increase in demand and the improvement of economic growth. If the demand for exports is elastic, there will be a great boost to exports.
Time Lag. In the short term, export demand is often inelastic, but over time it becomes more elastic to prices.
Reasons of depreciation / appreciation. It is often the most successful economies that appreciate. The currency is appreciated because there is more demand for its exports. Therefore, in this case, a depreciation will not cause a decline in economic growth, it will only limit the growth rate. If the currency is appreciated due to speculation, during a period of weak economic growth, the negative effect on growth may be more pronounced.