Exchange rates

NotesObjective Test

Exchange rates

An exchange rate is the price of one currency in terms of another, and is determined by the demand for and supply of the currency on the foreign exchange market.

Demand

Demand for the local currency (£) is created when:

  1. We Export goods or services

    Then demand for the local currency will increase as foreign currency revenue from export sales are converted into the local currency (eg from $ to £)

  2. Overseas investors invest in the local economy (UK).

Exports

Demand for the local currency (£) will rise as its exchange rate (its price) falls.

In other words, demand for £ rises when you get more £ for $1, then you want to buy more £, therefore the Demand for £ rises.

And local currency is cheap and therefore Exports are cheaper (eg. US can buy more  for $1 in the UK) and therefore Exports increase.

Illustration 1

A UK car maker EXPORTS cars to the USA.

The required revenue per car is £10,000.

If the exchange rate is $1.2 per £1 (as it was in 2018) then a price of 10,000 x 1.2 = $12,000 is charged.

However, if the value of the pounds falls to $1.1 per £1 (in 2019) then a price of a car falls to $11,000 (10,000 x 1.1).

  • The price in dollars has fallen (from $12,000 to $11,000)

    So demand from US customers will increase, and 

    more cars will be exported to the USA as a result of a fall in the exchange rate.

Supply

Supply of the local currency (£) arises when:

  • Imports (here goods bought from the USA) are purchased. 

    The pounds used to pay for these will be supplied to the Foreign exchange market and will be converted from pounds to dollars

  • Local investors invest in overseas businesses.

Imports

Supply of the local currency (£) will fall as its exchange rate (its price) falls.

In other words, supply of £ falls when you get less $ for £1, then you want to SELL less £, therefore the SUPPLY of £ falls.

And local currency is EXPENSIVE and therefore Imports are expensive  (eg. You can buy LESS  for £1 in the US) and therefore Imports decrease.

Illustration 2

Imagine an American car maker is trying to sell cars in the UK. (Import cars)

The required revenue per car is $10,000.

If the exchange rate is $1.2 per £1 then a price of 10,000 / 1.2 = £8,333 is charged.

However, if the value of the pounds falls to $1.1 then the price of a car rises to £9,091 (10,000 / 1.1).

  • The price in pounds has risen (from £8,333 to £9,091)

    So, fewer US cars will be imported by UK consumers, because its more expensive and therefore the imports  into the UK from USA will fall 

    So, because the UK consumers won't need $ now, they will sell /offer LESS £. (to buy $)

    Therefore, the Supply of £ will FALL.

    Therefore, the level of imports into the UK from USA will fall as a result.

Exchange rates and the balance of payments

A lower exchange rate will cause an increase in exports and reduce imports

A potential solution to a balance of payments deficit is to reduce the exchange rate.

Exchange rates and interest rates

Interest rates will affect the demand for a currency

eg lower interest rates will cause a fall in demand from overseas investors (eg US) looking to put money on deposit in the local economy (eg in the UK).

If interest rates fall the demand for the currency will also Fall (because people are not interested in it because in £), leading to a fall in the exchange rate.

Exchange rates and inflation rates

If a country experiences a rise in inflation rate (increase in prices) so that its rate is higher than that abroad this means that the country's products are more expensive relative to the goods produced abroad.

This will lead the demand for its exports to fall, and therefore the demand for its currency to fall.

NotesObjective Test