Exchange Rates

Define exchange rates

• Tells us how much of 1 currency can be exchanged for another

• The price of 1 currency relative to another

• For example, if the price of £1 in dollars is $1.34: the exchange rate between pounds & dollars is 1.34

Why would an individual sell or supply pounds?

Consumers sell or supply pounds when they want to exchange them for another currency. This may be for tourism abroad where UK consumers sell their pounds in exchange for foreign currencies. Or, it may be to pay for imports.

How is the demand for a currency is determined?

Demand for a currency is determined by tourists coming to the UK (inbound tourism) and demanding pounds. Also, when foreign consumers demand pounds in order to purchase exports coming from the UK. 

An appreciation of the exchange rate will occur if...

Demand for pounds shifts right and/or supply of pounds shifts left

A depreciation of the exchange rate will occur if...

Demand for pounds decreases and/or supply of pounds increases

Define speculation

• When investors predict changes in an exchange rate to make a profit

• For example, if they predict the exchange rate will appreciate, they’ll buy £s when it’s cheap and then sell £s when it’s more expensive to make a profit

Which of the following shows the impact of a appreciation of the pound?

When the pound appreciates, it can buy more foreign currency and so foreign imports become cheaper

Which of the following shows the impact of a depreciation of the pound?

When the pound depreciates, it can buy less foreign currency and so foreign imports become more expensive

What will be the impact of an appreciation in the pound on aggregate demand?

AD will decrease as imports increase and exports decrease ; import expenditure outflows from the economy

What will be the impact of an depreciation in the pound on aggregate demand?

AD will increase as imports decrease and exports increase ; export revenue inflows into the economy