Exchange Rates and Currency Movements

Understanding Exchange Rates

• Exchange rates are determined by the forces of demand and supply in the currency market.
• Changes in demand and supply can lead to fluctuations in exchange rates.

Appreciating Exchange Rates

• Definition: An appreciating exchange rate means the currency can buy more of another currency.
• Example: Initially, 1 pound = $1.60. If demand for pounds increases, 1 pound might buy $1.80, indicating a stronger pound.

Causes of Increased Demand for a Currency

1. Higher Relative Interest Rates

   • If UK interest rates rise relative to the rest of the world, foreign investors will want to deposit funds in the UK to earn higher returns.
   • This increases demand for pounds as foreign investors exchange their currency for pounds.

2. Speculation

   • Traders may anticipate a rise in the pound's value and buy pounds to sell at a higher rate later.

3. Increased Foreign Direct Investment

   • Foreign companies setting up in the UK need to exchange their currency for pounds to pay expenses, increasing demand for the pound.

4. Rising Incomes Abroad

   • Wealthier foreigners may buy more UK exports, requiring them to exchange their currency for pounds.

5. Increased Competitiveness of UK Exports

   • If UK goods become more competitive internationally, demand for these exports rises, boosting demand for the pound.

Depreciating Exchange Rates

• Definition: A depreciating exchange rate means the currency buys less of another currency.
• Example: If 1 pound = $1.60 but depreciates to buy only $1.40, the pound is weaker.

Causes of Increased Supply of a Currency

1. Falling Relative Interest Rates

   • If UK interest rates fall, investors may move their money to other countries, increasing the supply of pounds as they exchange them for other currencies.

2. Reduction in Foreign Direct Investment

   • If foreign firms leave the UK, they exchange pounds for other currencies, increasing the supply of pounds.

3. Rising Incomes Domestically

   • As UK citizens become wealthier, they may buy more imports, which requires exchanging pounds for foreign currencies.

Conclusion

• Exchange rate changes are influenced by factors affecting demand and supply.
• Understanding these dynamics is crucial for predicting and responding to currency fluctuations.

Key Takeaways

• Learn the causes that lead to appreciation and depreciation of a currency.
• Recognize the importance of relative interest rates, investment flows, and trade competitiveness.
• Mastery of these concepts is essential for understanding and navigating foreign exchange markets.

Study Tip: Review the factors affecting currency demand and supply to better understand exchange rate movements.