Economics | Exchange rates

Welcome to the Global Economy: Understanding Exchange Rates!

Hello future economists! Exchange rates might sound complicated, but they are simply the "price" of one country’s money in terms of another’s. If you’ve ever planned a holiday abroad or bought something online from another country, you’ve dealt with exchange rates!

In this chapter, we will learn how these rates are set, why they change, and how those changes affect you, your country's businesses, and the entire global economy. Don't worry if this seems tricky at first—we will break it down step-by-step!

1. What is an Exchange Rate?

An exchange rate is the value of one currency expressed in terms of another currency. It tells you how much of Currency B you can get for one unit of Currency A.

Key Definitions

• Currency: The system of money used in a particular country (e.g., the Pound Sterling (£), the US Dollar ($), the Euro (€)).
• Exchange Rate: The price of one currency in terms of another.

Example: If the exchange rate is £1 = $1.25, it means that one British Pound can buy one dollar and twenty-five cents.

Analogy: Think of a currency like any other product, say a loaf of bread. The exchange rate is its price tag. If you want to "buy" US Dollars, you have to "pay" in Pounds.

2. Appreciation and Depreciation

Exchange rates are constantly fluctuating. We use specific terms to describe whether a currency is getting stronger or weaker.

Currency Appreciation (Strengthening)

Appreciation means that the value of a currency has risen relative to another currency. You can buy more foreign currency with your domestic currency.

• Example: If the rate changes from £1 = $1.20 to £1 = $1.30.
• The Pound has appreciated because it now buys 10 cents more than before.

Result: Imports become cheaper for UK consumers (we can buy more foreign goods). Exports become more expensive for foreign buyers.

Currency Depreciation (Weakening)

Depreciation means that the value of a currency has fallen relative to another currency. You can buy less foreign currency with your domestic currency.

• Example: If the rate changes from £1 = $1.30 to £1 = $1.20.
• The Pound has depreciated because it now buys 10 cents less than before.

Result: Imports become more expensive for UK consumers. Exports become cheaper for foreign buyers.

Memory Aid: If the exchange rate number goes up (1.20 to 1.30), your currency has appreciated (it's worth more). If the number goes down, it has depreciated.

3. How Exchange Rates are Determined (The Floating Rate System)

In most major economies, the exchange rate is determined by the forces of supply and demand in the foreign exchange market (Forex), just like the price of any other good.

The Market for the Currency (e.g., The Market for Pounds £)

We look at the demand for Pounds and the supply of Pounds. The equilibrium rate is where demand equals supply.

A. Demand for Pounds (£)

Who demands (wants to buy) Pounds? Foreigners who need Pounds to pay for UK goods, services, or assets.

Demand for Pounds comes from:

1. UK Exports: Foreigners buy UK products (e.g., French citizens buying British cars).
2. Foreign Direct Investment (FDI) into the UK: US firms building a factory in Manchester.
3. Financial Flows: Foreigners buying UK assets (shares, bonds, property) or putting money into UK banks.
4. Tourism: Foreign visitors spending money in the UK.

B. Supply of Pounds (£)

Who supplies (wants to sell) Pounds? UK residents who need foreign currency to pay for foreign goods, services, or assets.

Supply of Pounds comes from:

1. UK Imports: UK residents buying foreign products (e.g., UK citizens buying German electronics).
2. UK FDI Abroad: A British company building a warehouse in China.
3. Financial Flows: UK residents buying foreign assets or putting money into foreign banks.
4. Tourism: UK residents going on holiday abroad.

Key Takeaway: An increase in demand for the Pound (shift right) or a decrease in supply of the Pound (shift left) will cause the Pound to appreciate (get stronger).

4. Major Factors Causing Exchange Rate Fluctuations

What specific events cause the demand or supply curves to shift, leading to appreciation or depreciation?

4.1. Changes in Trade (Current Account Balance)

• If UK Exports rise (Demand for £ increases): Foreigners need more Pounds to pay for UK goods.
  Result: £ appreciates.
• If UK Imports rise (Supply of £ increases): UK residents need to sell more Pounds to buy foreign goods.
  Result: £ depreciates.

4.2. Interest Rates and Financial Flows

Interest rates are extremely important. When a country raises its interest rates, it makes saving money in that country's banks more profitable. This attracts 'hot money' from overseas.

• If UK Interest Rates increase: Foreign investors move money to the UK to get better returns. They must first demand Pounds.
  Result: £ appreciates.
• If UK Interest Rates decrease: Money flows out of the UK seeking better returns elsewhere (Supply of £ increases).
  Result: £ depreciates.

Did You Know? This movement of short-term money based on interest rates is often called "hot money" because it moves very quickly in response to changes!

4.3. Inflation Rates

If the UK has a higher rate of inflation than its trading partners, UK goods become relatively more expensive.

• Foreigners stop buying UK goods (Demand for £ falls).
• UK residents buy more cheaper foreign goods (Supply of £ rises).
• Result: £ depreciates.

4.4. Confidence and Speculation

Speculation means betting on future movements. If traders believe the Pound will rise tomorrow, they will demand (buy) Pounds today, hoping to sell them for a profit later.

• High Confidence/Positive News about the UK economy: Increased demand for the £, as investors want to hold a currency that looks strong.
  Result: £ appreciates.

5. Systems of Exchange Rates (Fixed vs. Floating)

There are two main ways a government manages how its currency’s value is set:

A. Floating Exchange Rate System

This is the system we discussed in Section 3, used by most major economies (like the US, UK, and Eurozone).

• Definition: The value is determined entirely by market forces (supply and demand) without government intervention.
• Advantage: The government does not need to use up its foreign currency reserves to maintain the rate. The system acts as an "automatic stabilizer" for the economy (e.g., if exports fall, the currency depreciates, making exports cheaper again).
• Disadvantage: High volatility and uncertainty, which can make long-term international trade and investment planning difficult for businesses.

B. Fixed Exchange Rate System

Used by some smaller economies or those linking to a major trading partner (e.g., countries linking their currency to the US Dollar).

• Definition: The government (or Central Bank) promises to keep the exchange rate within a very narrow band (or fixed exactly) against another currency or a basket of currencies.
• Mechanism: To maintain the fixed rate, the Central Bank must intervene in the Forex market.
  • If the currency starts to fall (depreciate), the Central Bank must demand its own currency (buy it) using its reserves of foreign currency (Dollars/Euros).
  • If the currency starts to rise (appreciate), the Central Bank must supply its own currency (sell it) and accumulate foreign reserves.
• Advantage: Certainty and stability for businesses, encouraging international trade and investment. Helps reduce inflationary pressures.
• Disadvantage: The government must hold large reserves of foreign currency, which can be expensive. The government loses control over its domestic monetary policy (like setting interest rates) because rates must be used to defend the fixed rate.

6. The Effects of Exchange Rate Changes

The appreciation or depreciation of a currency has widespread effects on consumers, businesses, inflation, and the balance of payments.

Effect 1: Impact on Prices and Trade Balance

This is perhaps the most important concept to master. Let’s use a simple mnemonic:

Mnemonic for a Strong (Appreciated) Pound (£):

Strong Pound Imports Cheaper Exports Dearer

If the Pound Appreciates:

1. Imports: Become cheaper. This benefits consumers (cheaper goods) and firms that rely on imported raw materials.
2. Exports: Become dearer (more expensive) for foreigners. This harms domestic firms, potentially reducing export volumes and employment.
3. Trade Balance: Imports rise and exports fall, worsening the country's balance of trade (or current account deficit).

If the Pound Depreciates (Weakens):

1. Imports: Become dearer (more expensive). This is bad for consumers.
2. Exports: Become cheaper for foreigners. This boosts export volumes, benefiting domestic firms and employment.
3. Trade Balance: Imports fall and exports rise, improving the country's balance of trade.

Effect 2: Impact on Inflation

• Appreciation: Helps fight inflation because imported goods become cheaper (lowering costs for firms and prices for consumers).
• Depreciation: Can increase inflation because imported goods and raw materials become more expensive (called cost-push inflation).

Effect 3: Impact on Foreign Investment (FDI)

• Depreciation: Makes domestic assets (like property or factories) cheaper for foreigners to buy in terms of their currency. This can attract more FDI.
  Example: If the Pound weakens, a US company needs fewer Dollars to buy a British factory.
• Appreciation: Makes domestic assets more expensive for foreigners, potentially discouraging FDI.