Exchange Rate Appreciation and Depreciation

Understanding Exchange Rates

• Exchange rates are determined by the forces of demand and supply in the currency market.
• Changes in demand and supply affect the price of a currency, leading to appreciation or depreciation.

Example: Pound to Dollar Exchange Rate

• Initial equilibrium: 1 pound = $1.60.
• If demand for pounds increases, the exchange rate appreciates (e.g., 1 pound = $1.80).
• If demand for pounds decreases, the exchange rate depreciates (e.g., 1 pound = $1.40).

Reasons for Currency Appreciation

1. Increase in Relative Interest Rates

   • Higher UK interest rates attract foreign investors.
   • Foreigners exchange their currency for pounds to invest, increasing demand for pounds.

2. Speculation

   • Traders anticipate a rise in the pound and move money into pounds to profit.

3. Increase in Foreign Direct Investment (FDI)

   • Foreign firms set up in the UK, requiring pounds for operations (factories, wages, etc.).

4. Rise in Incomes Abroad

   • Foreign consumers have more money and demand more UK exports.
   • They purchase in pounds, increasing demand for the pound.

5. Increased Competitiveness of UK Exports

   • Factors such as lower unit labor costs, lower inflation, and higher productivity make UK exports more competitive.
   • Increased demand for exports increases demand for the pound.

Reasons for Currency Depreciation

1. Decrease in Relative Interest Rates

   • UK becomes less attractive for foreign investors, who move money out, increasing supply of pounds.

2. Decrease in FDI

   • Firms leaving the UK exchange pounds for other currencies, increasing supply of pounds.

3. Rising Incomes Domestically

   • UK consumers demand more imports, requiring foreign currency.
   • Pounds are exchanged for foreign currencies, increasing supply of pounds.

4. Increased Domestic Demand for Imports

   • Similar to the above, increased import demand increases supply of pounds as they are exchanged for other currencies.

Conclusion

• Understanding the factors that cause appreciation and depreciation helps in mastering exchange rate changes.
• Appreciate and learn these factors for a better grasp of currency market dynamics.