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Determining The Value Of Exchange Rates

 

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 them.

        UK investment abroad

        Speculation.

 

As the exchange rate rises the supply of sterling will also rise and vice versa.

 

Equilibrium

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

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. 

 

ECONOMIC GROWTH

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.

 

INFLATION

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 overseas markets.

 

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.

 

MARKET SPECULATORS 

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 in value. 

 

 

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.

 

Global Foreign Exchange Markets

The exchange 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.

 

Currencies are 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

Exchange 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

Bi-Lateral Exchange Rate

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

  • The scale/size of any change in the exchange rate
  • Whether the change in the currency is short term or long term
  • How 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 rate?

 

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 economic slump.

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:

  • Cutting export prices (lower profit margins) to maintain competitiveness and market share
  • Out-sourcing components and raw materials from overseas
  • Seeking productivity / efficiency gains to keep unit labour costs under control
  • Investing 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.
  • Moving production overseas

 

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 payments. 

 

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 years.

 

Below are some of the main economic effects of a lower value for the pound

 

Inflation 

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 consumers.

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.

 

Imports 

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).

 

Wage Demands 

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.  

 

 

 

E-mail Steve Margetts