An exchange rate is the rate at which one currency
exchanges for another on the foreign exchange market. An example is £1:$1.50.
The demand for sterling (£s)
Sterling is demanded for several reasons:
To purchase UK exports – foreigners need sterling in order to
buy our exports (although this is usually done through a third party such as
the original importer). As
exchange rates rise so does the price of UK exports and therefore there
should be a fall in exports meaning a fall in the demand for sterling.
Foreign investment in the UK – Nissan may want to build a new
factory in the UK they need to spend pounds to do this.
Foreign investors may wish to put money in UK banks, perhaps attracted
by high rates of interest.
Speculation – Traders on the foreign exchange markets buy and
sell sterling for profit. A high
exchange rate usually means demand for sterling is low as traders realise
that the next movement is likely to be a fall in the exchange value.
This is the most important cause of short term exchange rate changes.
As the exchange rate rises the demand for sterling
falls and vice versa.
The supply of sterling (£s)
Sterling is supplied for similar reasons:
To purchase foreign imports – UK importers need to supply
sterling in order to buy foreign currency so that they can buy their imported
goods. As the exchange rate
rises, the price of imports falls, there should be an associated increase in
imports, which leads to an increase in the supply of sterling to pay for
UK investment abroad
As the exchange rate rises the supply of sterling will
also rise and vice versa.
The equilibrium exchange rate is shown below:
The equilibrium is set where D = S at £1:$1.40.
Changes in the exchange rate
A fall in the exchange rate is known as a
depreciation. A rise in the
exchange rate is known as an appreciation.
Causes of depreciation include:
High UK inflation – UK will sell less exports because they
are now too expensive (causing a fall in the demand for sterling).
The UK will buy more imports because they are now cheaper than UK
goods (causing an increase in the supply of sterling).
A fall in UK interest rates – The UK will attract less
foreign investment (causing a fall in the demand for sterling).
UK residents will now invest money in foreign banks which now have
more attractive rates than domestic banks (causing an increase in the supply
Speculation – Traders lose confidence in the pound expecting
it to fall in value, this w ill
mean they will sell sterling (causing an increase in the supply of sterling)
and they will not wish to buy sterling (causing a fall in the demand for
UK goods become less competitive – If foreigners no longer
wish to but UK products due to quality issues, changes in tastes etc.
then the demand for sterling will fall.