Understanding Exchange Rate Appreciation and Depreciation

Key Concepts

• Exchange Rate: The price of one currency in terms of another.
• Appreciation: An increase in the value of a currency relative to another currency.
• Depreciation: A decrease in the value of a currency relative to another currency.
• Market Forces: Demand and supply determine the exchange rate in a currency market.

Example Context

• Currency Example: British Pound (GBP) and US Dollar (USD).
• Initial Equilibrium: 1 GBP = 1.60 USD (denoted as P1, Q1).

Factors Affecting Exchange Rate

Appreciation of a Currency

• Increased Demand for the Pound: Leads to appreciation.
• Reasons for Increased Demand:
  1. Higher Relative Interest Rates: UK offers better returns compared to other countries, attracting foreign investments.
  2. Speculative Trading: Traders anticipate a rise in GBP and invest to profit from appreciation.
  3. Foreign Direct Investment (FDI): Foreign companies investing in UK require GBP for operations.
  4. Rising Incomes Abroad: More demand for UK exports as foreign buyers' purchasing power increases.
  5. Increased Competitiveness of UK Exports: Due to lower costs, inflation, and higher productivity.

Depreciation of a Currency

• Increased Supply of the Pound: Leads to depreciation.
• Reasons for Increased Supply:
  1. Falling Relative Interest Rates: Investors withdraw from UK due to lower returns.
  2. Decrease in FDI: Companies moving operations out of the UK.
  3. Rising Domestic Incomes: Increased demand for imports, requiring currency exchange.

Conclusion

• Exchange rates fluctuate due to changes in demand and supply.
• Important to understand these dynamics for economic and business implications.
• Mastering these concepts helps in predicting and understanding currency market behaviors.