Foreign exchange rates

An exchange rate is simply the price of one country's currency in terms of another. For example, if the exchange rate between the British Pound (£) and the US Dollar ($) is £1 = $1.25, it means one pound can be exchanged for one dollar and twenty-five cents. These rates are essential for the global economy. When a UK firm wants to buy raw materials from the USA, it must pay in US dollars. To do this, it sells its pounds to buy dollars. This exchange happens in the Foreign Exchange Market, often called the Forex or FX market. It's not a physical place, but a global, decentralised network of banks, corporations, and individuals trading currencies 24 hours a day. International trade, investment, tourism, and even sending money to family abroad all rely on the ability to exchange currencies.

In a floating exchange rate system, the value of a currency is determined by the forces of demand and supply, just like the price of any other good or service. The vertical axis of the diagram shows the price of the currency (e.g., Price of £ in $) and the horizontal axis shows the quantity of the currency being traded.

Demand for a currency: The demand curve is downward sloping. As the currency becomes cheaper, foreigners find the country's exports and assets more attractive, so they demand more of the currency to buy them. Demand for a currency (e.g., the pound, £) is created by:

• Foreigners wanting to buy UK exports of goods and services.
• Foreigners wanting to invest in the UK (e.g., building a factory or buying shares).
• Foreigners wanting to save money in UK banks.
• Tourists visiting the UK.

Supply of a currency: The supply curve is upward sloping. As the currency's value rises, it becomes cheaper for domestic residents to buy foreign goods and assets, so they supply more of their own currency to the market to exchange it. Supply of a currency (e.g., the pound, £) is created by:

• UK residents wanting to buy foreign imports of goods and services.
• UK firms wanting to invest overseas.
• UK residents wanting to save money in foreign banks.
• UK tourists going on holiday abroad.

The equilibrium exchange rate is found where the demand curve intersects the supply curve. At this point, the quantity of the currency that people want to buy is exactly equal to the quantity that others want to sell.

Since floating exchange rates are determined by market forces, any change in demand or supply will cause the exchange rate to change. These changes are called appreciation and depreciation.

Appreciation: This is when the value of a currency increases. It means one unit of the currency can now buy *more* of another currency. For example, if the exchange rate moves from £1 = $1.25 to £1 = $1.30, the pound has appreciated. Appreciation is caused by either an increase in demand for the currency or a decrease in supply of the currency. On a diagram, this is shown by the demand curve shifting right or the supply curve shifting left, leading to a higher equilibrium price (exchange rate).

Depreciation: This is when the value of a currency decreases. It means one unit of the currency can now buy *less* of another currency. For example, if the exchange rate moves from £1 = $1.25 to £1 = $1.20, the pound has depreciated. Depreciation is caused by either a decrease in demand for the currency or an increase in supply of the currency. On a diagram, this is shown by the demand curve shifting left or the supply curve shifting right, leading to a lower equilibrium price (exchange rate).

Several factors can shift the demand and supply curves for a currency, causing its exchange rate to fluctuate. The main causes are:

1. Changes in Demand for Exports and Imports: If a country's exports become more popular, foreigners will demand more of its currency to pay for them, causing the currency to appreciate. Conversely, if a country's residents buy more imports, they will supply more of their currency to the market to buy foreign currency, causing their currency to depreciate.

1. Changes in Interest Rates: If a country's central bank raises its interest rates relative to other countries, it becomes more attractive for foreigners to save their money there to earn a higher return. This inflow of 'hot money' increases the demand for the currency, causing it to appreciate.

1. Foreign Direct Investment (FDI): When foreign companies invest in a country (e.g., by building a factory), they must buy the local currency. This increases demand for the currency and causes it to appreciate. Conversely, if domestic firms invest abroad, they supply their currency to the market, causing it to depreciate.

1. Speculation: Speculators buy and sell currencies to make a profit from changes in their value. If speculators believe a currency is going to rise in the future, they will buy it now. This increase in demand can become a self-fulfilling prophecy, causing the currency to appreciate. The opposite is also true for depreciation.

1. Relative Inflation Rates: If a country's inflation rate is lower than its trading partners, its goods become relatively cheaper. This increases its exports, which increases demand for its currency, causing an appreciation.

Changes in the exchange rate have significant consequences for a country's economy, affecting prices, trade, and employment. A useful way to remember the effects on trade is with mnemonics:

Appreciation (A 'Strong' Currency): Use the mnemonic SPICED.

• Strong Pound Imports Cheaper Exports Dearer.
• Impact on Imports: Imports become cheaper for domestic consumers and firms. This is good for consumers as it increases their purchasing power. It's also good for firms that import raw materials, as it lowers their costs. This can help to reduce cost-push inflation.
• Impact on Exports: Exports become more expensive for foreigners. This is likely to reduce the quantity of exports sold, which can harm domestic firms in export industries, potentially leading to job losses. It can also worsen the country's current account balance (the value of exports minus imports).

Depreciation (A 'Weak' Currency): Use the mnemonic WPIDEC.

• Weak Pound Imports Dearer Exports Cheaper.
• Impact on Imports: Imports become more expensive. This is bad for consumers, as it reduces their purchasing power. It is also bad for firms that rely on imported components, as their costs will rise. This can lead to cost-push inflation (also called imported inflation).
• Impact on Exports: Exports become cheaper for foreigners. This is likely to increase the quantity of exports sold, which boosts domestic firms in export industries, potentially creating jobs. It can also improve the country's current account balance.

Governments can choose how their country's exchange rate is determined. There are three main systems:

1. Floating Exchange Rate System: This is the system we have focused on. The value of the currency is determined purely by the market forces of demand and supply with no government intervention. The UK, USA, Japan, and the Eurozone all use floating rates.

• *Advantage:* It adjusts automatically to economic shocks and the central bank is free to set interest rates to manage the domestic economy, not to defend an exchange rate.
• *Disadvantage:* The volatility and uncertainty can make business planning difficult and may deter trade and investment.

1. Fixed Exchange Rate System: The government or central bank sets the exchange rate at a specific level (a 'peg') against another currency (e.g., the US dollar) or a basket of currencies. They must then intervene in the forex market to maintain this rate. If their currency's value starts to fall, the central bank must buy its own currency using its foreign currency reserves. If its value starts to rise, it must sell its own currency.

• *Advantage:* Provides certainty for businesses, which encourages trade and investment. It can also impose discipline on a government's economic policy.
• *Disadvantage:* The central bank must hold large foreign currency reserves and cannot use interest rate policy to manage domestic issues like unemployment.

1. Managed Float System (or 'Dirty Float'): This is a hybrid system. The exchange rate is allowed to float on a day-to-day basis, but the central bank intervenes if it moves too far or too fast. They try to 'smooth out' fluctuations or guide the currency towards a more favourable level without committing to a specific fixed rate. Many emerging economies like China and India use a form of managed float.