4.2.6.4 Exchange Rates

• Exchange Rate: the price of one country's currency in terms of another country's currency
• There are three types of exchange rates: floating, fixed and semi fixed
• A floating exchange rate can also be called a flexible exchange rate
• When the exchange rate ( price of the currency) of the pound rises SPICED occurs, meaning fewer pounds will be demand because UK goods become more expensive, therefore demand for UK goods will fall
• When the exchange rate (price of the currency) of the pound falls WPIDEC occurs, meaning more pounds will be demanded as UK goods becoming cheaper therefore demand for UK good will rise
• There is a negative relationship between the price of the currency (exchange rate) and the quantity demanded of the currency
• A change in the quantity demand of the currency will cause a movement on the demand curve
• An appreciation in the pound cause a fall in the demand pf the pound - SPICED
• A Depreciation of the pound causes an increase in the demand for the pound - WPIDEC
• There are three other factors that can effect the demand for a currency (pound) :

  1. Price of UK goods relative to other countries
  2. The Real Relative Interest Rate
  3. Speculative pressure on the pound
• If the UK becomes more competitiveness (productivity increases, inflation decreases) then the price of UK good will fall, meaning more people will demand pounds to buy UK goods. The Demand Curve will shift right
• Real rate of Interest = nominal interest rate- rate of inflation
• If the real rate of interest rise relative to other countries, more people will demand pounds to place in UK banks, so the demand curve will shift right
• If speculators think that the pound will rise in value, they will purchase more pounds, so the demand of pounds will increase, causing the demand curve to shift right
• The diagram shows what would happen to the demand curve if:

  • The UK became more competitiveness
  • The real rate of interest increased
  • Speculators think the value of the pound will rise

  
• The supply of pounds comes from the UKs need to buy foreign good and services
• SPICED would increase UK residents desire to purchase foreign goods as they are cheaper, so the supply of pounds on the market will increase
• WPIDEC would reduce UK residents desire to purchase foreign goods as they are more expensive so the supply of pounds on the market will fall
• There is a positive relationship between the supply of a currency on a market and the price of the currency
• If the UK became less competitive (inflation increase, productivity decrease) , meaning the price of UK goods increase, fewer people will want pounds so they will supply them onto the market to buy other currencies, so the supply of pounds will increase. The supply curve will shift right.
• If the real rate of inflation falls relative to other counties, fewer people will want money in UK banks, their money is being eroded quicker due to inflation, meaning they will supply pounds to buy other currencies, so supply of pounds will increase. The supply curve will shift right.
• If speculators think the pound will fall in value, the will sell pounds on the market so they can buy a foreign currency, meaning supply of pounds will increase. The supply curve will shift right.
• The diagram shows what would happen to the supply curve if:

  • The UK became less competitive
  • The real rate of interest falls
  • speculators think the pound will fall

  
• In exchange rate £:$ in 2015 was 1 : 1.59
• In exchange rate £:$ in October 2016 was 1 : 1.22
• In exchange rate £:$ in 2023 was 1 : 1.27
• The exchange rate for the pound fell in 2016 due to Brexit as people lost confidence in the pound, so speculators supply more more to the pound onto the market, causing price to fall. Behavioral aspect -> herding
• A fixed exchange rate creates certainty
• A floating currency reduces the need for foreign currency reserves
• A floating currency gives a country freedom to set policy interest rates to meet objectives
• A floating currency may help prevent imported inflation
• A floating currency has less risk of a speculative attack
• A fixed exchange rate give a country certainty, which increase confidence fore inward investment
• A fixed currency reduces the cost of currency hedging for businesses
• A fixed currency increase stability which helps control inflation
• A fixed currency can lead to lower borrowing costs as there is a lower yield on bonds
• A fixed currency imposes responsibility on government policies
• A fixed currency leads to less speculation in the fixed exchange rate is credible
• Price Stability: A fixed exchange rate system provides a high degree of price stability since fluctuations in the exchange rate are minimized. This stability can help control inflation and provide a predictable environment for businesses and consumers.
• A fixed exchange rate can give Trade Confidence: Businesses can plan for transactions without worrying about sudden currency value changes, making cross-border trade more predictable and manageable.