Understanding Exchange Rates and Their Fluctuation

Key Concepts

• Exchange Rate: The value of one currency for the purpose of conversion to another.
• Appreciation: When a currency increases in value relative to another currency.
• Depreciation: When a currency decreases in value relative to another currency.

Determination of Exchange Rates

• Exchange rates are determined by the forces of demand and supply in the currency market.
• A market change in demand or supply can lead to changes in the exchange rate (appreciation or depreciation).

Example: Pound to Dollar Exchange Rate

• Initial equilibrium: 1 pound buys 1.60 USD.
• Increased demand for pounds: Shifts demand curve to the right, leading to a higher price (e.g., 1 pound buys 1.80 USD).

Factors Influencing Appreciation of Currency (Pound)

1. Increase in Relative Interest Rates:
   • Higher relative interest rates in the UK attract foreign investment, increasing demand for the pound.
2. Speculation:
   • Traders anticipate a rise in the pound's value and move money into pounds to make a profit.
3. Foreign Direct Investment (FDI):
   • Foreign firms set up operations in the UK, requiring them to exchange their currency for pounds.
4. Increased Incomes Abroad:
   • Foreigners with higher incomes demand more UK exports, requiring them to buy pounds.
5. Increased Competitiveness of UK Exports:
   • Falling unit labor costs, reduced inflation, or rising productivity make UK exports more competitive, boosting demand for pounds.

Factors Influencing Depreciation of Currency (Pound)

• Supply Shifts to the Right: More pounds are exchanged for other currencies, reducing the pound's value.

1. Decrease in Relative Interest Rates:
   • Lower relative interest rates lead investors to move money away from the UK, increasing supply of pounds in exchange for other currencies.
2. Reversal of FDI:
   • Firms move out of the UK and exchange their pounds for other currencies.
3. Increased Domestic Incomes:
   • Wealthier UK residents demand more imports, leading to more pounds being exchanged for foreign currencies.

Summary

• Appreciation involves increased foreign demand for the pound due to higher interest rates, speculation, FDI, increased foreign incomes, and competitiveness of UK exports.
• Depreciation involves increased supply of the pound as investors, firms, and domestic consumers exchange pounds for other currencies.
• Understanding these factors helps explain why and how currencies fluctuate in value.

End of Lecture