4.3 - Exchange Rates

• Exchange rates are the price of one currency in terms of another e.g. £1=$1.15
• An increase in the value of a currency is called appreciation and means that the currency is worth more e.g. £1 = $1.20
• A decrease in the value of a currency is called a depreciation and means that a currency is worth less e.g.£1 = $1.10
• The value of a currency will affect a businesses ability to import and export goods and services

  • Imports are those goods and services that we buy from other countries
  • Exports are those goods and services that we sell to other countries
• How Exchange Rates affect a Business

  • If the exchange rate is strong:
  • Businesses that import will be able to buy cheaper goods and services
  • Businesses that export will see less demand
  • If the exchange rate is weak:
  • There will be a greater demand from abroad for UK products
  • Input prices will increase if raw materials are imported
  • A business may be able to pass the additional costs onto the customer
• Acronyms to remember:

  SPICEE - (Strong Pound Imports Cheap Exports Expensive)

  WPIEEC - (Weak Pound Imports Expensive Exports Cheap)
• GG buys tinned tomatoes from Italy at €0.50 per tin. He buys 1000 tins per month (The exchange rate is £1 to €1.15)

  How much do tomatoes cost his business per month? (in £): £434.78

  If there is a depreciation to £1 to €1.10, how much does it cost now? £454.55
• An appreciation of the exchange rate would be caused by:

  • Increase in the demand for the currency
  • Decrease in the supply of the currency
  • Means the currency would be worth more
• A depreciation in the exchange rate would be caused by:

  • A decrease in the demand for a currency
  • An increase in the supply of a currency
  • Means that the currency is worth less
• There is a significant impact on consumers of movements in exchange rates:

  • An appreciation in the exchange rate leads to a stronger £
  • This makes imports cheaper
  • Therefore, consumers can buy more foreign goods
  • In effect, this increases disposable income
• There is a significant impact on consumers of movements in exchange rates:

  • A depreciation in the exchange rate will lead to a weaker £
  • The price of imports will increase, causing inflationary pressure
  • If the import is price inelastic the total amount spent on it will increase
  • In effect, this reduces disposable income
• There is a significant impact on producers of movements in exchange rates:

  • If the exchange rate appreciates this will make exports less attractive in terms of price competitiveness and imports more attractive
  • However, a stronger pound will lower the relative price of imports and may reduce the cost of imported materials
  • Therefore, UK producers can benefit from cheaper raw materials and finished goods. Changes in exchange rates can eliminate profits for a firm or increase returns dependent on which way they move
• Examples of the impact on producers for exchange rate movements:

  • For example, in June 2016 the £ hit a 31 year low against the $ after the UK voted to leave the EU. As a result, when US firms convert their UK profits into dollars there will be a significant loss as each £ buys less $
  • In the same way, British firms that operate heavily in the US market, such as Burberry and Top Shop, should see a significant increase in profit as they turn $s into £s
• There is a significant impact on producers of movements in exchange rates:

  • When an exchange rate weakens, it increases the price of imports, and potentially the rate of inflation. This is especially true for firms who rely on the import of primary raw materials
  • This might deter investment made by firms as they do not know the expected return on investment
  • It is likely that there will be both benefits and disadvantages of exchange rate movements
• Example of impact on producers from exchange rate movements:

  • if the £ appreciates against the $ then UK subsidiaries of the business will benefit from cheaper imports and the opposite will happen e.g. to an American subsidiary
  • There is no certainty as to the exact price of a currency on a daily basis, meaning that firms will struggle to budget, as they do not know their exact costs
  • This can have a negative impact on profits