2.4.4 Exchange rates

What is an exchange rate?

The value of one currency relative to another.

What is depreciation?

When a currency loses value compared to another in a floating exchange rate system.

What is appreciation?

When a currency gains value; each unit can buy more of another currency.

What is devaluation?

An official lowering of a currency’s value in a fixed exchange rate system.

What is revaluation?

An official increase in a currency’s value relative to a baseline (gold, another currency, etc.).

What is a floating exchange rate?

Currency value is determined by supply and demand in the market.

What is a fixed exchange rate?

Currency value is set by the government; central bank can buy/sell currency to maintain the rate.

How does depreciation affect UK exports?

Makes them cheaper and more competitive; firms can lower prices to increase sales or keep prices to increase profit margins.

When might depreciation not boost export sales?

If goods are price inelastic or if foreign demand is weak due to low income or confidence.

How does depreciation affect imports?

Imports become more expensive; costs for firms rise, reducing international competitiveness and profits.

How can firms reduce exchange rate risk?

Fixed contracts for imports ensure prices don’t change with exchange rate fluctuations.

What is the effective exchange rate (EER)?

A weighted index showing a currency’s strength against a basket of other currencies, based on trade importance.

Why does the EER change?

If trade patterns change, the weight of each partner currency in the basket changes.