Understanding Exchange Rate Appreciation and Depreciation

Exchange Rate Basics

• Exchange rates are determined by the forces of demand and supply in the currency market.
• When demand and supply change, the price (exchange rate) can appreciate (increase) or depreciate (decrease).

Example: Pound to Dollar Exchange Rate

• Initial equilibrium: 1 pound = $1.60.
• If demand for the pound increases, the exchange rate appreciates (1 pound might now buy $1.80), meaning the pound is stronger.

Reasons for Pound Appreciation

1. Increase in Relative Interest Rates

   • Higher interest rates in the UK attract foreign investments.
   • Foreigners convert their currency to pounds to invest in the UK, increasing demand for the pound.

2. Speculation

   • Traders anticipate a rise in the pound's value and buy pounds to make profits, increasing demand.

3. Increase in Foreign Direct Investment (FDI)

   • Foreign companies setting up in the UK need to pay in pounds, increasing demand.

4. Rise in Incomes Abroad

   • Wealthier foreigners may demand more UK exports, needing pounds to purchase goods.

5. Increased Competitiveness of UK Exports

   • If UK goods become more competitive (due to lower labor costs, inflation, or higher productivity), foreign demand for exports rises, increasing demand for pounds.

Reasons for Pound Depreciation

• Initial equilibrium: 1 pound = $1.60. If it depreciates, 1 pound might buy only $1.40.

1. Fall in Relative Interest Rates

   • Lower interest rates in the UK cause investors to withdraw investments, converting pounds to other currencies, increasing supply of the pound.

2. Decrease in Foreign Direct Investment

   • Foreign companies withdraw from the UK, exchanging pounds for other currencies.

3. Increase in Domestic Incomes

   • UK residents buy more imports, requiring conversion of pounds to other currencies, increasing supply.

Summary

• Currency appreciation occurs when demand for a currency increases relative to its supply.
• Currency depreciation occurs when the supply of a currency increases relative to its demand.
• Understanding these dynamics is crucial for grasping how exchange rates fluctuate.