The global market for foreign exchange currencies is massive.
Hundreds of billions of £s and $s are traded in the dealing rooms
each day. The market is open 24 hours a day for people, companies and
governments needing foreign exchange to finance their transactions. Money
now moves round the international financial system at tremendous speed (aided
by the spread of computer technology and the gradual abolition of exchange
controls between countries). Speculative activity in the market is a major
determinant of a currency's value.
Short and long-term movements in the exchange rate, like any price, are
caused by changes in market demand and supply conditions
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.
Fundamental Factors That Drive A Currency
Interest rates have a large effect in a world where financial
capital can move freely between countries. When a country's interest
rates are high relative to elsewhere this attracts inflows of money into a
country seeking to take advantage of the high interest rates. This
"interest differential" boosts the demand for the currency and can
cause its value to rise.
Countries experiencing a deep recession often find that their
exchange rate is weakening. Traders in the currency markets may take the slow
growth to be a sign of general economic weakness and "mark down"
the value of the currency as a result.
On the other hand, economies with strong "export-led" growth
may see their currency's rise in value. Japan is a good example of this in
recent years. The Euro was weak during the first six months of its existence
in part because the financial markets were worried about the slow growth of
the European economy and the persistently high level of unemployment.
In the long run, those countries with higher than average inflation see
their exchange rate fall. When inflation is high, a country becomes less
competitive in international markets causing a fall in exports (a demand for
a currency) and a rise in imports (a supply of currency overseas). A fall in
the exchange rate may be needed to restore a country's competitiveness in
THE BALANCE OF PAYMENTS
Selling exports represents a demand for the domestic currency from
foreign importers. When US consumers but British Whisky they supply dollars
and this is eventually translated into a demand for pounds.
Similarly when UK consumers buy imports, they supply their own currency
and this is eventually translated into a demand for foreign currencies. If a
country is running a substantial trade surplus there is a large demand for
the currency and its value should appreciate. By contrast a massive trade
deficit usually causes the currency to lose value.
Special factors (such as political events, changing commodity prices
etc.) can have an effect on a currency. In addition the power of market
speculators has grown. When speculators decide that a currency is going to
fall in value, they sell that currency and buy ones they anticipate will rise
It is difficult for government's to offset the power of speculators
because their reserves of foreign currencies are very small compared to daily
turnover in the market. We saw in 1997 and 1998 speculative attacks on
currencies in Asia and seven years ago, the pound was forced out of the
European exchange rate mechanism because of speculative selling of the pound.
rate measures the external value of sterling in terms of how much of another
currency it can buy. For example - how many dollars you can buy with £1000.
The daily value is determined in the foreign exchange markets (FOREX) where
billions of $s of currencies are traded every hour.
traded around the world in a truly global market. The scale of
currency transactions is enormous. In London alone over $450 billion worth of
currency is bought and sold each day with London easily the largest FOREX
market in the world.
Measuring the UK exchange rate
rate index (EER)
The EER is a
weighted index of sterling's value against a basket of international
currencies Weights used are determined by the proportion of trade between the
UK and each country
This is simply
the value of sterling against another country. No weighting is made
concerning the importance of trade. Two examples would be sterling against
the Euro (i.e. the 12 member nations of the Euro Zone) or sterling against
the US dollar
Economic Effects Of Exchange Rate Changes
Changes in the exchange rate can have a powerful effect on the economy -
but these effects take time to show through. There are time lags between a
rise or a fall in the exchange rate, and changes in variables such as
inflation, GDP and exports & imports.
Much depends on
scale/size of any change in the exchange rate
the change in the currency is short term or long term
businesses and consumers respond to exchange rate fluctuations
WINNERS AND LOSERS FROM EXCHANGE RATE FLUCTUATIONS
In recent years the sterling exchange rate has risen appreciably against
a range of other leading currencies - not least the Euro since its inception
in January 1999. Who are the main gainers and losers from a rising exchange
An appreciation of the exchange rate has economic consequences both in
the short and long term. As the economy adjusts to a higher exchange rate,
some of the main beneficiaries and losers start to emerge.
Advantages of a strong pound
A high pounds leads to lower import prices - this boosts the real living
standards of consumers at least in the short run - for example an increase in
the real purchasing power of UK residents when travelling overseas
When sterling is strong, it is cheaper to import raw materials,
components and capital inputs - good news for businesses that rely on
imported components or who are wishing to increase their investment of new
technology from overseas countries.
A strong exchange rate helps to control inflation - domestic producers
face stiff international competition from cheaper imports and will look to
cut their costs accordingly. Cheaper prices of imported foodstuffs etc. will
also have a negative effect on the rate of consumer price inflation.
Disadvantages of a strong pound
Cheaper imports leads to rising import penetration and larger trade
deficit e.g. the £28bn trade deficit in goods in 2000
Exporters lose price competitiveness and market share - this damages
profits and employment in some sectors - notably manufacturing industry in
the last three years
If exports fall, this has a negative impact on economic growth. Some
regions are affected more than others. The strength of sterling in the last
five years is one of the factors highlighted when economists analyse the
north-south economic divide in the UK
Many business organisations have identified the strength of the exchange
rate as a major economic problem over recent times.
Economists argued in the summer of 2001 that the pound should be lower by
at least 10% in order to prevent manufacturing industry falling into an
However it should be noted that business can adapt to a high exchange
rate. There are ways in which industries can adjust to the competitive
pressures that a strong pound imposes. Some of the options include:
export prices (lower profit margins) to maintain competitiveness and
components and raw materials from overseas
productivity / efficiency gains to keep unit labour costs under control
resources in new product lines where both domestic and overseas demand is
more price inelastic and less sensitive to exchange rate fluctuations.
This involves producing products with a higher income elasticity of
demand, where non-price factors are more important in securing orders.
THE EFFECTS OF AN EXCHANGE RATE DEPRECIATION
A depreciation of the pound sees the pound fall against other
currencies. The economic effects of a lower pound take time to happen -
economists say that there are time lags between a change in the
exchange rate and changes in, for example, inflation and the balance of
The last major depreciation in the value of sterling came in the
early-mid 1990s following sterling's departure from the exchange rate
mechanism. The pound was devalued by nearly 15% against a range of currencies
in September 1992 and continued to drift lower in value for the next three
Below are some of the main economic effects of a lower value for the
A fall in the exchange rate makes imported goods and services more
expensive in the UK. Producers may then pass on higher costs of imported
components and raw materials onto consumers. This causes extra
"cost-push" inflation. Wages may rise in response to this
triggering off the possibility of a wage-price spiral.
The extent to which a depreciation of the pound causes inflation depends
in part on how dependent producers are for their imported components and also
their willingness to "price to the market" and pass on costs to
In a recession demand for many goods is elastic and a lower pound may
have little effect on retail price inflation.
Exports And The Balance Of Payments
Exporters should benefit from a lower pound (even allowing for the
inevitable time lags). A depreciation makes UK goods cheaper priced in a
foreign currency. Demand for exports will grow faster if the demand for
UK goods overseas is elastic.
The demand for imports should fall as imports become more expensive.
However, some imports are essential for production or cannot be made in the
UK and have an inelastic demand - we end up spending more on these when the
exchange rate falls in value. This can cause the balance of payments to
worsen in the short run (a process known as the J curve effect, see unit 3).
Partly due to higher inflation and falling real incomes, wages may rise.
This depends on what stage of the economic cycle the economy is in. When
unemployment is high, workers may have little confidence that their wage
demands will be met.
Economic Growth (GDP)
Higher exports (an injection into the circular flow) and falling imports
leads to rising GDP levels.