Exchange Rates

Definition The price of one country’s currency in relation to that of another

Rising and falling If the value of a currency falls in relation to the value of another currency then it is said to have depreciated (or fallen) in value e.g. £1 = $2 falls to £1 = $1.60 – the £ will have depreciated here and the $ has appreciated If the value of a currency rises in relation to the value of another currency then it is said to have appreciated (or risen in value).

Types of ER systems A free floating ER system is where the ER is determined by market forces and other factors; the price of one currency against another with fluctuate against other currencies A fixed ER system is where the ER is fixed to a certain price and central banks or governments need to maintain this level. ERM (the predecessor of the €) was a fixed ER system. The gold standard was a fixed ER system

£/$ Exchange Rate November % devaluation to $ /11/1949 Devaluation of 30% to $2.80

£/$ Exchange Rate Weak £ £ leaves ERM 1992

Factors that affect exchange rates Volume of exports – an increase in exports will mean that pounds are required to buy these products, causing an increase in the demand for Sterling and cause the value of Sterling to rise. A decrease in UK exports will have the opposite effect Volume of imports – an increase in imports will mean that more Sterling has to be sold in order to purchase the foreign currency needed to buy imports. This will increase the supply of Sterling and cause the value to fall. A decrease in imports will have the opposite effect

Factors that affect exchange rates Interest rates – a rise in interest rates will attract savings from abroad. This will raise demand for Sterling and its price. Speculation – if speculators expect the value to fall they will sell the currency, thereby causing the value to fall further.

Factors that affect exchange rates Government intervention – governments may try to influence the price of its currency by raising interest rates or by buying reserves on foreign currency markets Investment and capital flows – an inflow of capital for long term investment will cause the demand and therefore the price to rise

Effects of the value of the £ Exchange rate UK priceUS price Exports£1 = $2£10 £1 = $1.60£10 Imports£1 = $2$20 £1 = $1.60$20

The basic rule Fall = exports cheaper Rise = imports cheaper This is based on the domestic market!

How are businesses affected? Consumers’ response – some goods might not change (inelastic). Some might tend towards cheaper imports. Businesses with elastic products are more likely to be sensitive to changes in exchange rates Control over prices – some businesses with brand loyalty may not have to change its prices, especially if they were making large profits before the change.

How are businesses affected? Importing components and raw materials – many businesses have to import components and raw materials which can affect the selling price of their goods. This can mean that prices need to rise! As the UK imports a lot of raw materials, most businesses are affected by exchange rates This can be guarded against by future trading in currency or buying in bulk (which brings its own difficulties, e.g. storage)

How are businesses affected? Fluctuating exchange rates mean that uncertainty is created – this makes it difficult to plan A profitable business can be turned into a loss making business because of exchange rates

Eurozone

The effects of the € Consumers and businesses can easily identify price differences There is no need to change currencies – which reduces costs Reduces uncertainty for businesses and makes planning easier Costs of changing machines, cash systems and training A single interest rate exists in the € countries which might not suit all countries