4.1.8 Exchange rates

Exchange rate

The weight of one currency relative to another.

Purchasing power of a currency

What can be bought in other currencies.

Floating exchange rate

Determined solely by the forces of demand and supply of the GBP £.

Forces affecting demand

Exports of goods and services, inflows of FDI, speculation, inflows of 'hot money'.

transition mechanism of increased exports of goods and services

Foreign consumers want to buy product or services from the uk so foreign consumers all exchange(buy) £s using their different currency causing demand for £ to increase

transition mechanism of inflows of FDI

More investment from abroad will lead to Investors exchanging their currency for the £ in large amounts causing an increase in demand for £ as UK will receive more of another country's currency

transition mechanism of Speculation

Investors believe the value of the £ will rise in the future so speculators hear and buy the currency now to sell later when exchange rates rise and because speculators are buying the £ with their currency that in turn increases the demand for the £ and therefore increases the value for the £

transition mechanism of Inflows of 'hot money'

Increase in the UK interest rate so there is better return on uk saving accounts therefore it attracts foreign investors to save in £s ( taking advantage of the high IR) which will result in increased demand for £ and appreciation of value for £

Advantages of floating exchange rate

Automatic adjustment of BoP, flexibility, low requirement to hold foreign exchange reserves.

Automatic adjustment of BoP

Countries with large BoP deficit will find their currency weakens.

Flexibility in exchange rates

The government isn't tied into maintaining a particular exchange rate.

Low requirement to hold foreign exchange reserves

A floating system negates the need for large reserves.

Freedom to pursue macroeconomic objectives

Resources can be used for other objectives without constraint.

Disadvantages of floating exchange rate

Uncertainty, speculation, inflation, damage to investment.

Uncertainty in exchange rates

There is no certainty as to the exact price of a currency on a daily basis.

Inflation from weak exchange rates

Increases the price of imports and potentially inflation.

Damage to investment

Investment might be discouraged due to uncertainty and inflation.