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Exchange rates
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The exchange rate is the price of a currency. Its changes affect what a country pays for imports and earns from exports.
How exchange rates are set
An exchange rate is the price of one currency in terms of another, such as £1 = $1.30.
In a floating system, it is set by the demand for and supply of the currency.
Demand rises when foreigners buy the country's exports, when interest rates are high (attracting savings from abroad) and when speculators expect it to rise.
Supply rises when residents buy imports or invest abroad.
In a floating system, it is set by the demand for and supply of the currency.
Demand rises when foreigners buy the country's exports, when interest rates are high (attracting savings from abroad) and when speculators expect it to rise.
Supply rises when residents buy imports or invest abroad.
Rises and falls
Appreciation: a rise in a floating currency's value due to market forces.
Revaluation: a deliberate rise in a fixed currency's value by the government or central bank.
Depreciation: a fall in a floating currency's value.
Devaluation: a deliberate fall in a fixed currency's value.
Revaluation: a deliberate rise in a fixed currency's value by the government or central bank.
Depreciation: a fall in a floating currency's value.
Devaluation: a deliberate fall in a fixed currency's value.
Effects
£1 = $1.20. A UK firm sells a product for £500. What is its price in dollars? If the pound appreciates to $1.40, what is the new price?
- 500 × 1.20 = $600
- 500 × 1.40 = $700
Answer: $600, rising to $700
Exchange rates are set by demand and supply of a currency, influenced by trade, interest rates and speculators. Appreciation/revaluation make exports dearer and imports cheaper; depreciation/devaluation do the opposite.
The interactive lesson includes the diagrams for this topic.
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