Exchange rates

The exchange rate between two currencies is the price of one in terms of the other, for example, if it costs $1.50 to buy £1.00 then the exchange rate  will be £1.00 = $1.50.


The UK has followed a number of different exchange rate systems since the 2nd World War:

  • 1944-72: Fixed exchange rates, but there were devaluations against dollar in 1948 and 1967.
  • 1972-87: Managed floating exchange rates
  • 1987-88: Shadowing the deutschemark.
  • 1988-90: Managed floating in the run up to joining the exchange rate mechanism.
  • 1990-92: Semi fixed exchange rates.
  • 1992-today: Floating exchange rates.


This chapter will explain the different types of exchange rate system and European Monetary Union.


Historical Movements in Exchange Rates


Describe the changes in the exchange rate in the above chart.




Describe the changes in the exchange rate in the above chart.






Describe the changes in the exchange rate in the above chart.






Trade weighted index

The trade weighted index is used to compare a country’s exchange rate against its major trading partners.  The weight for each foreign currency is equal to its share in trade.  The Bank of England publishes data for the pound called the Exchange Rate Index (ERI).


Describe the changes in Sterling’s ERI.





Was the recent decline in the ERI expected?  What is the evidence to support this view?





Floating Exchange Rate Systems

Free Floating

Changes in the demand and supply of a currency will lead it to either appreciate or depreciate.  Short run factors that will affect the demand for a currency include:

  • To purchase goods and services from another country.
  • To invest in another country.
  • Speculating on the currency.
  • To take advantages of rises in interest rates.


In the long run, it is the macro economic performance of the economy that will drive the value of the currency.  The price of a currency is determined using the normal interactions of demand and supply.


There is no official target for the exchange rate set by the government or central bank.  This allows interest rates to be set to pursue other economic targets rather than attempting to achieve a certain exchange rate.

What objective are interest rates in the UK used to pursue?




A free floating exchange rate can be used as an automatic stabiliser to reduce a deficit on the current account on the balance of payments.


The pound has free floated on the foreign exchange markets since the UK suspended membership of the ERM in September 1992.


Managed Floating

Again, the value of the pound is determined by demand and supply with no pre-determined target.  In cases of extreme appreciation or depreciation, the central bank will normally intervene to stabilise the currency.  Governments frequently engage in managed floating; this was the policy pursued from 1973-90.



The exchange rate is given a specific target.  The currency is allowed to move between permitted bands of fluctuation.  The Bank of England and other central banks may have to intervene to maintain the value of the currency within the set targets.  This was followed between October 1990 and September 1992 when the UK was part of the ERM.


Fixed Exchange Rate Systems

This requires the exchange rate to be fixed against one or more other currencies and no fluctuations are allowed.  The UK was part of the Bretton-Woods System between 1944 and 1972 where currencies were tied to the US dollar.  The countries joining the euro tied the currencies to each other in 1999 until the euro was introduced in January 2002.


Fixed rates gives greater certainty for firms who export and import goods and services as they are able to plan future costs and revenues with greater certainty.


If firms know that a currency won’t be devalued they are more likely to be more disciplined with their approach to minimising costs.

Why will a firm have more incentive to keep costs under control if it knows that the currency won’t be devalued? 




Economic and Monetary Union (EMU)

The euro is the official currency of 16 of the 27 member states of the European Union; the countries that use the euro are collectively known as the Eurozone  The euro has been officially adopted by Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.  It is used daily by some 327 million Europeans and it is the currency with the highest value of cash in circulation in the world.


The euro was introduced as an accounting currency to the world financial markets on 1 January 1999 and notes and coins entered circulation on 1 January 2002.


In order to be allowed entry to the euro each member state are meant to meet the growth and stability pact –an annual government budget deficit of less than 3% of GDP and total government debt to be less than 60% of GDP –, low inflation, stable exchange rates and interest rates close to the EU average.


With the UK remaining outside of the Eurozone, there is great debate as to whether the UK should join.  There are a number of advantages that have been highlighted of joining the euro:

  • Reduced transaction costs for firms and individuals.  Transaction costs are the costs of changing one currency into another.
  • Reduced exchange rate uncertainty will help with business planning.
  • Increase trade with member countries.
  • Greater price transparency as firms and consumers will find it easier to compare prices as they will be quoted in the same currency.
  • Being a member of the euro should lead to increased foreign direct investment as firms will want to trade within the Eurozone.
  • The UK can only hope to have greater economic and political influence if it is a member of the Eurozone.
  • The optimum currency theory suggests that geographical areas would benefit from having the same currency.
  • Lower interest rates were often quoted as being a reason for joining the euro, however recent months have seen the Bank of England’s base rate fall below the ECB’s.


There are also some disadvantages of the UK joining the single currency:

  • The Bank of England would lose control over monetary policy.  Interest rates would be set by the ECB and they may not be set at the most appropriate level for the UK at any particular point in time.
  • The Bank of England sets monetary policy with the secondary objectives of sustainable growth and high levels of employment in mind.  This would not be the case if interest rates were set by the ECB.
  • Other countries have not stuck to the growth and stability pact.
  • The UK is more sensitive to changes in interest rates than other European countries due to its high percentage of home ownership.
  • There are very high conversion costs of switching over to the euro; these are one off sunk costs.


The UK government has used five tests to make a decision on euro membership, they are:

  • Convergence.  Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?
  • Flexibility.  If problems emerge is there sufficient flexibility to deal with them?
  • Investment.  Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?
  • Financial Services.  What impact would entry into EMU have on the competitive position of the UK’s financial services industry, particularly the City’s wholesale markets?
  • Growth and employment.  Will joining EMU promote higher growth, stability and a lasting increase in jobs?


On 9th June 2003 the Government published the assessment of the five economic tests.  The Treasury’s assessment was that since 1997 the UK has made progress in meeting the five economic tests.  But, whilst it acknowledged the potential benefits of increased investment, trade, a boost to financial services, growth and jobs are clear, it could not conclude that there was sustainable and durable convergence or sufficient flexibility to cope with any potential difficulties within the euro area.  Therefore the government decided that despite the risks and costs from delaying entry, membership of EMU at that time would not have been in the national economic interest.

Do you think the UK should join the euro?


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