Influences on Exchange Rates…

Syllabus Aims Understand factors influencing exchange rates.

How well do you know your currencies? What currency is used in Japan? What currency is used in Switzerland? What currency is used in Greece? What currency is used in Brazil? What currency is used in India? What currency is used in Turkey? What currency is used in South Africa?

How well do you know your currencies? 1) What currency is used in Japan? Yen 2) What currency is used in Switzerland? Swiss Franc 3) What currency is used in Greece? Euro 4) What currency is used in Brazil? Upto 1993, the Cruzeiros… but now its called ‘Real’ (plural Reais) 5) What currency is used in India? Rupee 6) What currency is used in Turkey? Lira 7) What currency is used in South Africa? Rand

SPICED! The reality for UK consumers! UK tourists abroad Political issues with £

Exchange rates: Exchange rates: are the price of one currency in terms of another. Bi-lateral exchange rates compare one currency against another eg £:$ Exchange rates are determined much like any other price in a free market, via demand and supply.

What has happened the £ exchange rate? When has the £ been strong? When has the £ been weak? 1992 = Black Wednesday….. What factors do you think have caused these changes in the value of the £?

Factors that influence £ 1. Inflation 2. Interest Rates 3. Speculation 4. Change in competitiveness 5. Relative strength of other currencies 6. Balance of Payments But how?

Factors that influence £ 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.

Factors that influence £ 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 surplus 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)

The exchange rate is determined at the point where the demand curve and supply curve for sterling on the foreign exchange market meet.

The demand curve for sterling 1. Demand for the pound comes from demand for our exports from abroad. We want to be paid in pounds, no matter where our customers come from, and so people abroad have to purchase pounds on the foreign exchange market. If demand for exports increases, then demand for the pound on the foreign exchange market increases. 2. Demand for the pound also comes from demand for saving in UK bank accounts — if the UK interest rate goes up compared to interest rates abroad, then people abroad will want to save their money in UK bank accounts. Because you can save only pounds (rather than dollars or euros) in UK banks, … demand for the pound on the foreign exchange market will rise if the interest rate rises. The stocks of funds that move around the world in search of the best return is called hot money. 3. Long term capital movements are also important. So, inwards investment into the UK increases demand for the pound.

The supply curve for sterling 1. Supply of the pound onto the foreign exchange market comes from our demand for imports. People abroad want to be paid in their own currency, so we take our pounds along to the foreign exchange market, releasing them on to the market in return for other currencies. So, supply of the pound on the foreign exchange market increases if demand for imports increases. 2. If the interest rate abroad increases relative to the interest rate in the UK, then funds will move from the UK to overseas bank accounts, increasing the supply of the pound on foreign exchange markets. 3. If there is net outwards investment from the UK economy, then the supply of pounds will increase.

Current Exchange rate issues

Depreciation Depreciation means that the value of the £, in terms of other currencies, goes down. For example, £1 = $1.60 to £1 = $1.40 — in the second example, it takes fewer dollars to buy £1. With a depreciation, even though a good may still be priced at £10, it now costs Americans only $14 instead of $16 — demand will increase.

Appreciation Appreciation means that the value of the £, in terms of other currencies, goes up. For example, £1 = $1.50 to £1 = $1.70 —, it now takes more dollars to buy £1. With an appreciation, even though a good may still be priced at £10, it now costs Americans $17 instead of $15, therefore reducing demand for our exports.

Describe the relationship

Long term – current account & long term capital movements So which is worst? As the key factor that affects exchange rates, which would you perceive to be the worst…. Relative interest rates? Relative inflation rates? Speculation? Short term – by speculation – 80% of all currency trade is for speculation! Long term – current account & long term capital movements

Who gains and who loses from a fall in the external value of sterling? A2 Exchange Rates Who gains and who loses from a fall in the external value of sterling? Example Winner? Loser? Comment UK farmers   British farmers are in receipt of CAP subsidies which are fixed annually and paid in Euros at an exchange rate set at the level in September 2008. Publishers Pearson is a multinational publisher which marks school tests, produces learning materials and publishes the Financial Times and Penguin books. The group generates 60% of its sales in American dollars. The exchange rate has moved from $2 to the pound in 2007 to $1.44 at the 2008 year-end. Tourism Bed and breakfast businesses in London A glass manufacturer NJ Bradford is a business based in the West Midlands which supplies glass across a number of industries. Their main competitors come from China offering cheaper decorative and toughened glass products. Mrs G's notes

Who gains and who loses from a fall in the external value of sterling? Abattoirs in the Republic of Ireland   In the Republic of Ireland, more than 60 per cent of all food products are exported. A UK airline That buys most of its fuel from the international petroleum markets and pays in US dollars. Estate agents selling prime London property British people living in France and Spain on sterling pensions

Questions: What macro economic benefits can an economy have from a ‘weak’ currency? (4) Why are some countries adopting a strategy for higher inflation with a link to their government debts? (You will need to review inflation theory from last year to answer this!!) (4) What other implications could this high inflation strategy bring to their economy? (4) What benefits can a ‘strong’ currency have for an economy? (4) Describe two other strategies a government uses to ‘strengthen’ their currency? (4) 20 marks available