4.3 Exchange Rates

• The exchange rate is defined as ''the price of one currency in terms of another currency'' For example, you can sell £1 and receive $2.45 for it. A product which is priced at £1 in the UK will, if exported to the US, be priced at $2.45. Therefore, changes in the exchange rate will lead to changes in the prices of both imports and exports, and can therefore influence international competitiveness.
• The exchange rate of any country is determined by the supply and demand for that currency. *see diagram*

  • Demand for a currency is defined as ''the number of people/ firms wishing to buy that currency''. Anything that INCREASES demand for a currency will INCREASE the exchange rate.
  • Supply of a currency is defined as ''The number of people/firms wishing to sell that currency''. Anything that INCREASES supply of a currency will DECREASE the exchange rate.
• The effect of a rise in demand for a currency: *see diagram*

  • Increased demand (D1 to D2) for a particular currency results in a rise in the exchange rate from ER1 to ER2.
  • This may be influenced by: people wanting to buy UK exports, overseas residents wanting to save money in UK banks, people wanting to speculate by buying a currency today which may increase value in the future, and to invest in UK businesses.
• The effect of a rise in supply of a currency: *see diagram*

  • Increased supply of your currency as more people sell it results in a fall/ depreciation of the currency.
  • This may be influenced by: People in the UK wanting to buy imports, people in the UK wanting to save money in banks in other countries because higher IR's overseas will increase this incentive, people wanting to speculate on other currencies, and to invest in businesses in other countries.
• Calculating Currency conversions:

  To do this you need to -

  1)Know how many pounds you wish to convert

  2)Then multiply it by sterling's exchange rate.

  For example:

  • Convert £12.90 into dollars at an exchange rate of £1=$1.50.
  • £12.90 x 1.50= $19.35
• Overall, it's expected that a fall in interest rates will lead to a fall in the exchange rate.
• A fall in IR's in the UK means that there is now less reward for saving in UK banks. In turn, less people will buy sterling (to invest money into UK bank accounts), & more people will now want to transfer their money out of UK bank accounts, so more people SELL sterling. As a result, *see diagram* the rise in supply leads to a greater quantity of currency in the economy, and in turn, a fall in the ER.

  • Overall, this link between IR's and the ER explains how sig. monetary policy can be. This is because changes in the base rate will lead to changes in the ER, which impacts import/export prices.
• The advantages of a fall in the ER for consumers are:

  • Many consumers will have greater job security if they work in export-led industries, because exports are now cheaper and so more goods will be sold, as demand overseas increases.
  • Unemployment may fall, with increased export sales, firms may expand and employ more workers.
• The disadvantages of a fall in the ER for consumers are:

  • Imports into the UK are now more expensive, so there may be cost-push inflation. This is because consumers will have to pay higher prices if firms pass on the costs of higher raw materials prices.
  • UK consumers suffer from a worsening in their standard of living. This is because UK consumers find that they can buy less goods and services with their income.
  • UK consumers holidaying overseas will now find that their holidays are more expensive.
• The effect of a fall in the ER for consumers will depend upon how big the change in ER is.
• The advantages of a fall in the ER for producers are:

  • UK exports to other countries are now cheaper, leading to higher (X-M), and export-led growth. Use AD/AS to analyse.
  • Imports become more expensive so overall balance of trade improves.
  • Higher AD can lead to lower unemployment due to a higher 'derived' demand for labour
• The disadvantage of a fall in the ER for producers are:

  • Higher AD may be bad, i.e. demand-pull inflation
  • If there is inelastic PED for imports, people will keep buying them, despite the increase in price.
  • Higher import prices for raw materials can lead to cost-push inflation.
• The effect of a fall in the ER for producers will depend upon:

  • How big the fall in ER is
  • How long the ER remains low for
• The advantages of a rise in the ER for producers are:

  • Imports will be cheaper. Producers who have to import raw materials now have lower costs of production.
  • UK firms involved in providing overseas travel should see higher demand. This is because a rise in ER makes it cheaper for UK residents to pay for overseas holidays.
  • Possibility of lower demand-pull inflation, as the demand for UK exports falls.
• The disadvantages of a rise in the ER for producers are:

  • UK exports will be more expensive in overseas markets -> loss of export sales -> lower 'net-exports'. This may not be good for the trade balance.
• The effect of a rise in the ER will depend upon:

  • How big the change is
  • How long it remains at it's new level
• The advantages of a rise in the ER for consumers are:

  • The price of imports in the UK will fall, so many consumer goods will now be cheaper.
  • With cheaper imports, consumers will be able to buy more goods + services, so will benefit from improved living standards.
  • UK holiday makers overseas will be able to buy more foreign currency for every £1. Therefore, overseas holdings will be cheaper.
  • Possible fall in cost-push inflation due to cheaper raw materials for firms.
  • Possible fall in demand-pull inflation, with lower export sales
• The disadvantage of a rise in the ER for consumers are:

  • Firms may not pass on the benefits of lower import prices. They may choose to enjoy higher profits as their costs of production fall.
  • Consumers who work in export industries may become unemployed due to lower export sales.