Determination of Exchange Rates
- An exchange rate is the price of one currency in terms of another.
- Most countries’ exchange rates are determined by the forces of supply and demand.
- If demand for a country’s currency rises, this will increase its exchange rate.
- A rise in the exchange rate of a currency means that each unit of the currency will buy more units of another currency.
- A number of factors influence the demand for and supply of a currency:
- The international competitiveness of a country’s products
- If UK products are internationally competitive, foreigners will want to buy these products, and so would want to buy pounds to buy them, hence increasing demand.
- UK consumers would also not be wanting to sell many pounds to buy foreign products – decreasing the supply of pounds
- The income of people in foreign countries
- If incomes are rising abroad, then they are more likely to buy UK products, increasing demand and increasing the exchange rate.
- The income of domestic consumers
- If this increases, then the exchange rate is likely to fall, as the supply of pounds will increase so that UK consumers could purchase more imports.
- The interest rate relative to other countries’ interest rates
- If the interest rate in the UK is higher than another country’s, then its citizens are likely going to want to buy pounds in order to take advantage of the high interest rate that UK financial institutions offer – increasing the demand
- The amount of FDI in a country
- If a foreign firm wants to buy a UK company or open up a new factory in the UK due to high labour productivity or favourable government policies, then they’re going to have to buy pounds to do this, which will increase demand.
- Speculation
- Speculators buy and sell currencies, in hoping to profit from the changes in them
- This can have a stabilising or a destabilising effect on the currency
- If the exchange rate is falling, a speculator could see his share of it, which would further increase supply and lower the exchange rate – destabilising it
- However, if the exchange rate is falling, a speculator could buy the currency, in hoping to profit from it going up.