Exchange rates

How exchange rates are determined by market forces

An exchange rate is the price of one currency in terms of another e.g. The price of a British pound (GBP) in US dollars (USD).

In order for British consumers and producers to buy goods and services from the USA they need to sell GBP and buy USD that they can pay their American suppliers with. In a similar vein American individuals and firms who want to buy British goods and service need to sell USD and buy GBP.

So as can be seen in the example above, demand for GBP comes from foreigners who want to buy British goods and services, while supply comes from UK individuals and businesses that want to buy froeign currency.

When the value of a currency is determined through the market forces of supply and demand it is said to be a floating exchange rate. However in some extreme situations governments may affect the markets through their policies.

Change to exchange rate	How it Can be caused	What it means
A rise in the exchange rate	A right shift of demand for the currency or a left shift of supply of the currency	The currency is appreciating in value e.g. One GBP is now worth more USD. British people and firms will pay less GBP for their goods and services bought in the US. However, US people and firms will pay more for their British goods and services.
A fall in the exchange rate	A left shift of demand for the currency or a right shift of supply for the currency	The currency is depreciating in value e.g. One GBP is now worth less USD. British people and firms will pay more GBP for their goods and services bought in the US. However, US people and firms will pay less for their British goods and services.

Factors affecting the demand and supply of pounds

We already discussed the key factor that affects supply and demand in the exchange market. However there are other factors that can affect supply and demand.

Factor	How it affects demand	Factor	How it affects supply
UK exports	If UK exports become more desirable then a lot of people in other countries will demand pounds (Right shift of demand). If they are less desirable then demand for pounds will fall (Left shift of demand).	UK imports	If foreign goods become less desirable then less people will want to supply pounds to the market (Left sift of supply). If they are more desirable then supply would increase (Right shift of supply).
Overseas incomes	If incomes are rising overseas they will be able to buy more goods and services from Britain meaning an increased deamand for pounds (Right shift of demand). If they are falling they can afford less british goods and services and demand decreases (Left shift of demand).	Domestic incomes	If domestic incomes rise people may be able to afford more foreign goods and services (Right shift of supply). If they fall then people will buy less imported goods and services (Left shift of supply).
Interest rate	If the interest rate in the UK is higher than the interest rate elsewhere then foreign people will want to buy pounds to deposit in UK banks and make more interest (Right shift of demand).	Interest rate	If the interest rate in the UK is lower than the interest rate elsewhere then UK people will want to buy foreign currency to deposit in overseas banks and make more interest (Right shift of supply).
Speculators	If speculators oversease think the value of the pound will rise they may buy it now to sell it later for profit (Right shift of demand).	Speculators	If speculators in the UK think the value of the pound will likely fall against another currency they ay buy that currency now and sell it back for more pounds later (Right shift of supply).

Analyse recent and historical exchange rate data

Using Trading economics you can click Markets and then Currencies and select the currency market you wish to view.

The price of GBP in USD has fallen from $1.60 at the start of the period to a low around $1.10 at the end. It has fluctuatd throughout but was relatively stable between $1.20 and $1.40 from 2016 until recently when it reached new lows. You might then get asked to explain how that impacts holiday makers from these countries or firms that trade between them.

Exchange rate for GBP to USD for the past 10 years

Evaluate the effect of changes in the exchange rate on consumers and producers

Effect of an appreciating exchange rate	How it affects consumers	How it affects producers
Imports	Comsumers get cheaper imported goods and services and may buy more of these.	Producers who import supplies for their production will benefit from lower costs which may mean they can lower prices and be more competitive.
Travel	It is cheaper for UK residents to travel as they can get more for their pound on holidays.	For firms that work in the travel industry this provides additional demand.
Lower interest	Comsumers with mortgages or those who wish to get one may benefit from lower rates and be left more disposable income because the Bank of England lowers rates to try to encourage investment to improve the UK's competitiveness.	Producers who wish to expand and benefit from economies of scale so they can become more competitive benefit from these lower interest rates too.
Lower inflation	Consumers benefit from the certainty of lower inflation because lower exports and higher imports means less overall demand in the country reducing demand pull inflation.	Lower inflation means less pressure on wages which in time can help the country back towards being more competitive.

For a depreciating exchange rate the effects are likely to be the opposite. Imports are more expensive which will reduce their consumption while our exports are cheaper and so we may be able to export more. This might mean more workers are needed to make the additional output needed for export. This would improve the country's balance of payments. The extra incomes this generates can be inflationary if supply cannot keep up with the demand from our now wealthier workforce. It will be more expensive to take a foreign holiday but more foreign tourists may be attracted to the UK which will benefit firms in the tourism and hospitality sectors.

The key thing to remember is whether it is appreciating or depreciating there will be both people who benefit and people who are worse off.

Knowledge check

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Exam style questions

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Questions

Explain what an exchange rate is. (2 marks)

The price of one currency(1) expressed in terms of another.(1)

Explain what a currency is. (2 marks)

The system of money(1) used in a country or group of countries.(1)

Explain how the exchange rate for GBP in USD is determined. (2 marks)

By the interaction of British consumers who supply GBP in return for USD they need for purchases from the US(1) and US consumers who demand GBP to buy British goods and services.(1)

Jacob is taking a trip to the USA. If £1 buys $1.10 US how much US spending money will he have when he converts his £1000 he has saved to take on the trip? (2 marks)

1000 x 1.10(1) = $1100(1)

Fred is in the USA but wants to purchase some supporter gear for his favourite Premier League team Chelsea. He has a budget of $100 US. How much is the most his items can cost in GBP to the nearest penny before he goes over his budget if £1 buys $1.10 US? (2 marks)

100 / 1.10(1) = £90.91(1)

Case study/Scenario

Analyse the effect of rising interest rates in the UK compared to other European countries on the market for GBP in EUR. (6 marks)

Sample answer:

If interest rates rise faster in the UK than elsewhere then the UK is a better place to save money.{AO1} More firms and individuals will want to save money in UK banks.{AO2} Leading to a right shift of demand{AO3a} and causing the equilibrium price of GBP in EUR to rise.{AO3a} The size of the difference in interest between the UK and other countries will affect the degree of change{AO2} with a larger gap resulting in bigger rises.{AO3a}

Case study/Scenario

In 2014 the GBP-USD exchange rate was £1 was worth $1.71 and it has declined now to £1 is worth $1.10.

Evaluate the effects of these chages on UK producers. (6 marks)

Sample answer:

The decrease in value of the pound would mean British exports were cheaper to US consumers{AO2} This could mean that they are able to sell more goods in the US{AO3a} and make more profit.{AO3a}

However, for producers who use inputs to production that come from the US those inputs will be more expensive, meaning they may have to raise prices{AO3b} which could result in lower sales and profit.{AO3b}

For producers that are exporters the effects could be very positive but for those that import goods from the US they could be very negative.{AO3b}