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Business & Exchange Rates |
Exchange rates |
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Exchange rates are the price of one currency in terms of another. For example, every £1 may purchase $1.5.
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Exchange rates may be either fixed or floating. When exchange rates are fixed the government seeks to ensure that the price of their currency in terms of other currency remains the same over time, and they will buy or sell their “reserves” of foreign currencies in order to achieve this. On the other hand, when exchange rates are floating, the government does not intervene and allows exchange rates to fluctuate in accordance with supply and demand for the currency.
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When interest rates go up, demand for the currency increases. This is because foreign investors can get a higher rate of interest by investing in that country, so they seek that country's currency and this increases demand for the currency and pushes the exchange rate up.
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Factors that increase demand for a currency include
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| 1 | | Greater demand for the goods and services produced by that country |
| 2 | | Greater desire to save in that country |
| 3 | | Speculation in that country's currency — a belief that the value of the currency will rise in the near future, so demand for that currency rises in the hope of buying cheap and selling at a higher price. |
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Factors that affect the supply of a currency include
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| 1 | | Greater demand for overseas goods and services (that is, for imports) |
| 2 | | Greater desire to save abroad |
| 3 | | Speculation against the currency. |
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The effect on firms of changes in exchange rates |
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An increase in the value of a currency (say, sterling) causes an increase in the price of UK goods and services abroad. This, like any price rise, is likely to lead to a fall in demand for UK goods and services. In other words, an increase in the price of a currency leads to a fall in exports.
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On the other hand, the increasing price of the currency means that foreign goods are cheaper, so this leads to an increase in imports.
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Export firms are, therefore, adversely affected by a rise in exchange rates. Companies that export have to prepare themselves for changes in exchange rates. An over “strong” pound can lead to serious effects for export companies.
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The precise impact of a change in exchange rates will depend on the nature of the export product. Products with high inelasticity are not price sensitive, so changes in the price of the product owing to changes in exchange rates will not adversely affect demand. Demand for highly specialised, differentiated goods will not be unduly adversely affected by an increase in the exchange rate.
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However, goods with elastic demand curves will be strong affected by exchange rates. An upward movement in the exchange rate could result in a strong decline in demand owing to the resultant increase in price.
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Managed Exchange Rates |
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Because of the damage that can be done to the economy when exchange rates change (fluctuate), there is often a desire for exchange rates to be fixed — or managed.
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Western economies operated on managed exchange rates from 1945 to 1971. The value of sterling and other currencies was linked to the dollar. However, from 1971 it proved impossible to maintain this system, owing to the presence in the world financial markets of huge amounts of capital, thus making it impossible for central banks to prevent speculative pressures forcing the value of their currencies up or down.
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One solution to the problem of managing exchange rates is to have a common currency. This is the solution adopted in the European Union, which now operates a single currency. Britain, however, remains outside the European currency union at present, and so still has its own currency (sterling) and experiences the problems of fluctuating exchange rates in relation to the rest of Europe.
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