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 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.

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 of sterling).

·        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 sterling). 

·        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.