Wednesday, 9 November 2011

Exchange Rates (Macroeconomics)

Exchange rates are something that affects all of us, be it directly or indirectly. Exchange rates are basically the value of a currency compared to that of another currency. They fluctuate a lot, which leads to price changes.

I'll be using the Sterling (£) in my examples throughout. Firstly, let's look at what determines the value of a currency. The value of the £ is determined by the free market, so therefore the powers of demand and supply dictate the value of the £. The majority of the demand for the £ will come from trading partners demanding the U.K's exports and therefore needing the £ to buy them. The majority of the supply of the £ comes from us demanding foreign imports, and needing to sell the £ to get foreign currency to buy the imports.

An increase in the demand for the £ will increase the value compared to other currencies. This is often referred to as a "strengthening of the £" or an "appreciation". Obviously, a fall in demand for the £ will have the opposite effect. An increase in the supply of the £ will decrease the value compared to other currencies. This is often known as a "weakening of the £" or a "depreciation". A decrease in supply will have the opposite effect, raising the value.

Another key factor that influences the demand and supply of the £ is interest rates. If interest rates in the U.K. are high, then we will see a high demand for the £ as people will make a better return off of it in U.K. banks. This will increase the value of the currency. A decrease in interest rates will see money flow out of the U.K. in search of a better return on their investment and therefore demand and the value of the £ will fall.

There are two different exchange rate mechanisms. The first one is the floating mechanism. This is when the value of the currency is determined by the free market - the powers of demand and supply. The advantage of this mechanism is that theoretically the exchange rate should automatically adjust which will eliminate any imbalances withing the Balance of Payments. The other is the fixed mechanism. This is when the exchange rate is fixed and determined by the government or central bank of a country. The bonus to this is that it gives more stability to the value of the currency but runs the risk of goods becoming to un-competitive if it's too high or the market can be flooded if it's too low.

That's the lot for exchange rates, thanks. Also, any requests for what to come next? Post it in comments and ill see what i can do. Thanks for reading, follow the blog if you enjoy!

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