Foreign exchange rates

When a transaction occurs between two countries, it usually involves swapping one country's currency for another. The 'price' of one currency in terms of another is called the foreign exchange rate. For example, if £1 = $1.25, it means one British pound can be exchanged for one dollar and twenty-five cents. These exchanges happen in the foreign exchange market (often called Forex or FX), a global, decentralised marketplace where currencies are traded. Individuals going on holiday, companies importing goods, and firms investing abroad all need to participate in this market to make payments.

Like any other market, the price of a currency is determined by the forces of supply and demand. The demand for a currency comes from foreign entities wanting to buy that country's goods, services, or assets. For example, a US firm buying French wine creates demand for Euros. The supply of a currency comes from domestic entities wanting to buy foreign goods, services, or assets. For example, a French citizen going on holiday to the US supplies Euros to buy dollars. The equilibrium exchange rate is found where the quantity of the currency demanded equals the quantity supplied.

In a floating exchange rate system, the value of a currency is constantly changing. A rise in the value of a currency is called an appreciation. This means one unit of the currency can now buy more of a foreign currency (e.g., the rate moves from £1=$1.20 to £1=$1.30). A fall in the value of a currency is called a depreciation. This means one unit of the currency now buys less of a foreign currency (e.g., the rate moves from £1=$1.20 to £1=$1.10). These changes are caused by shifts in the demand or supply curves. For example, an increase in demand for a currency (e.g., due to higher interest rates attracting foreign savers) will cause it to appreciate. An increase in supply (e.g., due to its citizens buying more imports) will cause it to depreciate.

Governments can choose how their currency's value is determined. There are three main systems:

1. Floating Exchange Rate: The value is determined purely by market forces of supply and demand with no government intervention. The UK, USA, and Japan use this.
2. Fixed Exchange Rate: The government or central bank sets a target value for the currency (pegs it) against another currency (e.g., the US dollar). They intervene in the Forex market by buying or selling their currency using foreign reserves to maintain this fixed rate.
3. Managed Floating Exchange Rate (or 'Dirty Float'): This is a hybrid system. The rate is allowed to float on the market, but the central bank intervenes to prevent large or rapid fluctuations. They might buy their currency to stop it from falling too fast, or sell it to stop it from rising too quickly. This is the most common system in the world today.

Changes in the exchange rate have significant effects on an economy. A useful acronym is SPICED: Stronger Pound, Imports Cheaper, Exports Dearer.

Appreciation (Stronger Currency):

• Imports become cheaper: Consumers and firms can buy foreign goods for less of their own currency. This helps to reduce inflation.
• Exports become more expensive: Foreigners must pay more of their currency to buy the country's goods. This can make exports less competitive, potentially reducing export sales and leading to job losses in exporting industries.
• Current Account: Tends to worsen (move towards a deficit) as import spending rises and export revenue falls.

Depreciation (Weaker Currency):

• Imports become more expensive: This can lead to 'imported inflation', as the cost of foreign raw materials and finished goods rises.
• Exports become cheaper: Foreigners can buy the country's goods for less of their currency. This makes exports more competitive, potentially boosting export sales, output, and employment.
• Current Account: Tends to improve (move towards a surplus) as export revenue rises and import spending falls.