Hello Future Economist! Welcome to Exchange Rates

Welcome to one of the most exciting and practical chapters in international economics: Exchange Rates.
Don't worry if this sounds complicated—it’s just the price of one country’s money in terms of another’s.
Every time you travel, buy something online from a foreign country, or see news about global trade, exchange rates are playing a vital role!

In this chapter, we will learn:

  • What an exchange rate is and how it is expressed.
  • Why currency values change (Appreciation and Depreciation).
  • How these changes affect businesses, consumers, and the overall economy.

1. What is an Exchange Rate?

Definition and Calculation

An exchange rate is simply the price of one currency expressed in terms of another currency. Think of it as the price tag for money itself.

If you live in the UK and want to buy something in the USA, you need to convert your British Pounds (£) into US Dollars ($). The exchange rate tells you how many dollars you get for each pound.

Key Term:
Exchange Rate: The value of one currency in terms of another.

Example: If the exchange rate is $1.25 = £1.00, it means that one British Pound can buy one dollar and twenty-five cents.

Quick Calculation Tip:

If you want to convert £100 into USD when the rate is $1.25 = £1.00, you multiply: $$ £100 \times 1.25 = \$125 $$

Did you know?
Exchange rates constantly fluctuate. They change every second during the working day, reflecting the actions of millions of buyers and sellers worldwide!

Key Takeaway: The exchange rate is simply a conversion factor, showing how much money you get in Currency B for Currency A.

2. Appreciation and Depreciation: Strengthening and Weakening

Currencies are traded in a market, and like any other good, their price (the exchange rate) can go up or down.

Appreciation (The Currency Gets Stronger)

Definition: An Appreciation occurs when the value of a currency rises in relation to others. It means your currency can now buy more foreign currency.

Example of Appreciation:

  1. Old Rate: £1 buys $1.20
  2. New Rate: £1 buys $1.30

The Pound (£) has appreciated. You now get 10 cents more for every pound you exchange.

Depreciation (The Currency Gets Weaker)

Definition: A Depreciation occurs when the value of a currency falls in relation to others. It means your currency can now buy less foreign currency.

Example of Depreciation:

  1. Old Rate: £1 buys $1.30
  2. New Rate: £1 buys $1.20

The Pound (£) has depreciated. It is now weaker because it buys 10 cents less than before.

Memory Aid: The "A" Rule

If the number (of foreign currency units you receive) goes UP, the currency Appreciates.

Key Takeaway: Appreciation means your money is worth more internationally; Depreciation means your money is worth less internationally.

3. How Exchange Rates are Determined

In a floating exchange rate system (where the government doesn't fix the price), the exchange rate is determined exactly like the price of apples or shoes: by the forces of Supply and Demand.

We must look at the supply and demand for the specific currency we are analyzing (e.g., the British Pound).

Demand for a Currency (Why people want it)

People (foreigners) need to demand or buy the local currency (e.g., Pounds) when they want to do anything in that country.

The Demand for £ comes from:

  • Exports: Foreigners buying UK goods and services (e.g., a German company buys Scotch Whisky). They must pay the UK supplier in Pounds, so they demand Pounds.
  • Inward Foreign Direct Investment (FDI): Foreign companies or individuals investing in the UK (e.g., a US company buys a factory in Manchester). They demand Pounds to pay for the purchase.
  • Tourism: Foreign tourists visiting the UK (They demand Pounds to pay for hotels and food).
  • Interest Rates: If UK interest rates are higher than elsewhere, foreign investors demand Pounds to put their money into UK savings accounts (attracting 'hot money').
If Demand for the Pound increases, the Pound appreciates.

Supply of a Currency (Why people offer it)

Local residents need to supply or sell their own currency (e.g., Pounds) when they want to buy foreign goods or invest abroad.

The Supply of £ comes from:

  • Imports: UK residents buying foreign goods and services (e.g., a British store buys Italian clothing). They must exchange their Pounds for Euros, thereby supplying (selling) Pounds.
  • Outward Foreign Direct Investment (FDI): UK companies investing abroad (e.g., a UK firm buys a company in Brazil). They supply Pounds to buy Brazilian Reals.
  • Tourism: UK tourists going abroad (They supply Pounds to buy foreign currency).
If Supply of the Pound increases, the Pound depreciates.

Quick Review Box

Higher Demand (e.g., more Exports) \(\rightarrow\) Appreciation (Stronger £)
Higher Supply (e.g., more Imports) \(\rightarrow\) Depreciation (Weaker £)

4. Factors That Cause Exchange Rate Changes

Any event that shifts the supply or demand curves for a currency will change its price (the exchange rate).

(A) Changes in Trade Flows (Imports and Exports)

  • Increase in UK Exports: If UK goods become popular, foreigners demand more Pounds to pay for them. Result: Demand for £ shifts right \(\rightarrow\) £ Appreciates.
  • Increase in UK Imports: UK consumers buy more foreign goods, meaning they supply more Pounds to exchange for foreign currency. Result: Supply of £ shifts right \(\rightarrow\) £ Depreciates.

(B) Changes in Interest Rates

Interest rates set by the central bank are a major factor. Money often flows to where the return (interest) is highest.

  • UK Interest Rates Rise: This makes saving money in UK banks more attractive to foreign investors ("hot money"). They must demand Pounds to deposit their money. Result: Demand for £ increases \(\rightarrow\) £ Appreciates.
  • UK Interest Rates Fall: Foreigners pull their money out and supply Pounds to exchange them for a currency with higher interest rates elsewhere. Result: Supply of £ increases \(\rightarrow\) £ Depreciates.

(C) Investor Confidence and Speculation

  • High Confidence: If investors believe the UK economy is strong, they speculate the Pound will rise in value. They buy Pounds now, hoping to sell them for a profit later. Result: Demand for £ increases \(\rightarrow\) £ Appreciates.
  • Low Confidence/Political Instability: If investors fear economic problems, they quickly sell off their Pounds before the value drops. Result: Supply of £ increases \(\rightarrow\) £ Depreciates.

Key Takeaway: Everything that makes the UK a more attractive place to invest or buy from leads to an appreciation.

5. The Impact of Exchange Rate Changes

Exchange rate changes have huge implications for every international transaction. It determines who wins and who loses.

Impact of an Appreciation (Stronger Currency)

When the local currency (£) appreciates, imports become cheaper and exports become more expensive.

Winners and Losers of Appreciation:
  • Domestic Consumers (Winners): Imported goods (like cars, electronics, fruit) are now cheaper. This increases their purchasing power and may reduce inflation.
  • Importers (Winners): It costs them less local currency (£) to buy the same quantity of foreign goods. Their profit margins may increase.
  • Domestic Exporters (Losers): Their products become more expensive for foreigners to buy. This hurts their competitiveness and reduces sales volume abroad.
  • Current Account Balance (Effect): A strong currency tends to worsen the current account because exports fall (due to high prices) and imports rise (due to low prices).
  • Tourism (Losers): The country becomes an expensive destination for foreign tourists.
Analogy: Imagine the Pound is a very heavy, expensive shopping basket. Foreign buyers don't want to carry it, but local buyers love it because it fills up with cheap imports.

Impact of a Depreciation (Weaker Currency)

When the local currency (£) depreciates, imports become more expensive and exports become cheaper.

Winners and Losers of Depreciation:
  • Domestic Consumers (Losers): Imported goods are now more expensive. This can lead to imported inflation (costs of goods and raw materials rise).
  • Importers (Losers): It costs them more local currency (£) to pay for their goods.
  • Domestic Exporters (Winners): Their products are now cheaper and more competitive in foreign markets, potentially increasing sales and profitability. This helps create jobs in export industries.
  • Current Account Balance (Effect): A weak currency tends to improve the current account because exports rise (cheap) and imports fall (expensive).
  • Tourism (Winners): The country becomes a cheaper destination for foreign tourists, attracting more visitors.

Common Mistake to Avoid: Don't assume appreciation is always "good" or depreciation is always "bad." It depends entirely on who you are—an exporter loves depreciation, but a consumer hates it!

Final Summary and Encouragement

You’ve covered a complex but vital topic! Remember that exchange rates are a fundamental link between the domestic economy and the global economy. They determine whether your country’s businesses can compete internationally and how much everyday items cost.

Keep practicing the connection: Demand \(\rightarrow\) Exports / Investment In \(\rightarrow\) Appreciation
Supply \(\rightarrow\) Imports / Investment Out \(\rightarrow\) Depreciation

Keep up the great work! You’ve mastered the language of global money.