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Exchange Rates

A2 Economics Presentation

2005

What is the Exchange Rate? (1)

• The exchange rate is simply the value (or purchasing power) of a currency in terms of what it can buy of other currencies

• Valuations of each currency are determined in the foreign exchange markets

– Global currency markets are open 24 hours per day

• London is the main centre of global currency dealing

What is the Exchange Rate? (2)

• A large share of trading is purely speculative

• Other currency flows are the result of

– (a) Trade flows in goods and services

– (b) Capital flows (e.g. net flows of foreign direct investment)

Measuring the Exchange Rate

• Bi-lateral exchange rate

– The exchange rate between two distinct currencies• £/ $ (cable rate)• $ / YEN• Sterling / Euro• Euro / Yen

• Exchange rate index (EER)

– Sterling's average value against a basket of currencies• Weighted against the proportion of trade that the UK does with

each country• Heavily weighted currencies are the Euro and the dollar• Gives an indication of the overall strength or weakness of the

UK currency in international markets

Currency Demand

• Currency demand

• Demand for currency comes from a need to purchase the currency of a particular economy

• The main sources of demand are

– Exports of goods

– Exports of services

– Inflows of foreign investment

– Speculative demand

– Official buying of sterling by Bank of England

Currency Supply

• Supply of currency comes from economic agents needing to demand overseas currency in exchange for their own

• The main sources of supply are

• Imports of goods

• Imports of services

• Outflows of foreign investment

• Speculative selling

• Official selling of sterling by the Bank of England

Expectations and Speculation

• Example:

– Current exchange rate is £1 = $1.50

– You expect the value of sterling to rise

– You spend $600,000 today and buy £400,000

• Two months later the pound has appreciated so that £1 = $1.60

– You sell the £400,000

– You get $640,000 in exchange

• Successful currency speculation can lead to significant capital gains

• The greater the expected profit – the higher the speculative demand for sterling at a given rate of interest

• (This example ignores transactions costs)

Uncovered Interest Rate Parity

• The basic principle: Money is worth what it can earn

• Example:

– Money in a UK deposit account earns 6% a year

– Money in a Euro-based account earns 4% a year

– Assume that exchange rate expectations between sterling and the Euro are constant

– “Footloose” Money will flow out of Euros and into Sterling

– A positive interest rate differential will lead to an increased demand for sterling in currency markets

– Net demand for sterling suggests that sterling will appreciate against the Euro

– Therefore - changes in interest rates will affect the differential and cause changes in “hot money” flows between currencies

– But …..much depends on investors attitude to exchange rate risk

What drives the exchange rate?

• Macroeconomic performance

– Inflation in one country relative to another

– International trade performance (net balance of trade)

– Government finances

• Interest rate differentials between countries

• Net capital flows between countries

• Perceptions of currency traders in the market

– Is the currency at its equilibrium level

– Fundamental equilibrium for an exchange rate?

The Sterling Exchange Rate Index

United Kingdom Effective Exchange Rate Index

Source: EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Ind

ex

80

85

90

95

100

105

110

115

Exchange Rate and Inflation

• Changes in the prices of imported goods and services – this has a direct effect on the consumer price index

• Commodity prices: Many internationally traded commodities are priced in dollars

• Changes in the growth of UK exports – movements in the exchange rate affect the competitiveness of UK export industries in global markets

• Wage bargaining – some economists believe that the exchange rate influences the power of employees to bargain for increases in real wages

Exchange rate & competitivenessData is for the manufacturing sector only, source OECD

UK Competitiveness - Relative Unit Labour Costs

Source: EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q390 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

1995 I

ND

EX

65

70

75

80

85

90

95

100

105