Exchange rates

An exchange rate is the price at which one currency exchanges for another one.

Jump to questions on exchange rates

How are exchange rates measured?

Nominal rates

Exchange rates can be measured in nominal terms - in other words, the rate at which a single currency exchanges for another currency (a bi-lateral value). Bi-lateral rates are also known as 'tourist' rates, such as £1 exchanging for $1.25.

Real rates

Real exchange rates reflect what a currency can actually buy and reflects the purchasing power of a particular currency. (Read more on purchasing power adjustments).

Trade weighted rates

Trade weighted rates are expressed in terms of an index, and indicate how a currency is performing in terms of several other rates. The U.S. dollar index (USDX) and the Sterling Trade-Weighted Index are two such indices. Currency changes are ‘weighted’ to reflect the relative importance of different currencies in relation to trade.

How are exchange rates determined?

How rates are determined depends upon the system (or 'regime') used.

There are three basic exchange rate regimes:

1. Fixed rates - where the rate of one currency is pegged to another currency or precious metal
2. Floating rates - where rates are determined in the Foreign Exchange (forex) market, and vary according to the relative demand and supply of currency
3. Managed systems - which combine elements of fixed and floating systems

Floating rates

In a completely freely floating system rates are determined by the forces of demand and supply operating in the foreign exchange market. The demand and supply of currencies originates from the need to pay for international transactions in local currencies.

When consumers, firms, or organisations in one country buy another country’s products or invest in their assets they must exchange their currencies. The demand and supply of currencies ultimately comes from trade and investment flows.

For example, rates are pushed up when demand for a country's currency increases as its exports or investment opportunities become more popular abroad. Rates are pushed down when the reverse happens, and more is imported from abroad, or the country invests more in other countries.

Exchange rates are also affected by speculation and changes in relative interest rates, and inflation rates. Confidence levels also affect activity on the foreign exchange market.

Changes in market exchange rates

Changes in market rates under a floating regime are referred to as appreciation and depreciation. The diagram shows that an equilibrium exchange rate exists when the demand for and supply of a currency equal each other. The diagram relates to the equilibrium rate between the GB pound and the US dollar.

At the equilibrium rate, the foreign exchange market clears. At the equilibrium rate, the simple model of exchange rate determination suggests that the value of import spending and export revenue will balance.

Any changes to the value of imports or exports will shift the supply or demand for a currency - an increase in imports shifts the supply to the right, and an increase in exports shifts the demand to the right.

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If we assume the starting equilibrium is at a (where £1 = $1.20) an increase in exports will push demand for the currency to the right, with the equilibrium moving to e¹, and the exchange rate appreciating to £1 = $1.25). However, an increase in imports will shift the supply of pounds to S1, causing downward pressure on the exchange rate, which falls (depreciates) to £1 = $1.15.

Speculation

Speculation by financial organisations and their traders can also have a considerable effect on the foreign exchange market. If traders expect rates on financial assets to rise, they are likely to purchase them in the hope of making a speculative gain. This would increase demand, and if enough speculators have the same intention, the currency would, as expected, be driven up.

Bulls and bears

A bull market in forex trading describes any market where currency prices are rising or are expected to rise in the future. This encourages them to buy the currency.

In contrast, in a bear market, the expectation is that currency prices are going to fall in price and traders will look to sell their holding of that currency. (Source: Forex.com)

Interest rates

Changes in interest rates also have an effect on currency values. Higher interest rates in one country can increase a currency's value because an increase in interest rates (relative to other countries) would attract more overseas investment in a country’s financial assets – this would increase the demand for currency. It is partly through this vehicle that a central bank can ‘manage’ and stabilise an exchange rate.

Relative inflation rates

Purchasing power parity (PPP) theory states that, in the long run, price differences for identical or very similar traded goods will eventually be removed through changes in the exchange rate. This is because price differences will lead to arbitrage, so that traders will exploit price differences until they are identical.

Therefore, inflation in one country relative to another will lead to a depreciation of its exchange rate by the same proportionate amount, hence, eventually removing the impact of inflation.

For example, let’s assume a tonne of Norwegian steel sells in Norway for 50000 Norwegian krone (kr) [kr50000], and that the exchange rate between £ and kr is £1= kr10. Therefore, a trader in London would have to pay £5000 to get hold of this tonne.

Now let’s say, inflation in Norway pushes up the price of steel to kr55000 (at 10% increase). The London trader will now reduce demand for Norwegian steel which reduces demand for the Norwegian krone. PPP theory says that the krone will fall until it reaches its pre-inflation level in London – i.e. fall by 10% to £1 = kr11. This means that, while a tonne of steel in Norway is kr55000 it still sells in London for £5000 (55000/11).

For this to work, three conditions must be met:

1.  No transportation costs, barriers to trade, and other transaction costs – which in reality can be significant.
2.  Markets must be competitive for the goods and services in both countries.
3.  This only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.

N.B. Short run movements in exchange rates are unlikely to be affected by short term movements in relative inflation rates.

Fixed rates

In contrast, a fixed system involves currencies being pegged by a country’s central bank, or through a ‘currency board’. For example, the Hong Kong currency board pegs the Hong Kong dollar to the US dollar, and only issues Hong Kong dollars at this fixed rate.

The first use of gold to fix currency values, the Gold Standard, dates back to 1831. High levels of inflation associated with the First World War eroded confidence in gold, and eventually, in 1931, the Britain left the system. (Source: The Royal Mint).

Britain’s exit caused a collapse in the system, so that by 1934 only 12 countries were left on gold compared to 45 countries in 1931. Those remaining on gold included Belgium, France, and the Netherlands, but they left the system later in the decade⁽¹⁾.

After the Second World War, the IMF system was established, with most currencies having a fixed value against the US dollar, which itself was pegged to gold, but this also collapsed (in 1971), leaving national currencies to either float freely, or be pegged, or even abandoned as countries formed single currency zones, such as the Eurozone.

(1) (Source: Kitson.M, 2012 End of an Epoch: Britain’s Withdrawal from the Gold Standard, Judge Business School, University of Cambridge.)

Managed rates

A managed system exists when the exchange rate is manipulated to achieve a particular objective, such as to encourage exports by allowing the rate to reach a low level where export demand is stimulated in order to correct a balance of trade deficit.

There are various types of managed regimes, but all use some kind of pegging to achieve a particular objective, or to deal with a particular circumstance.

How do governments intervene to influence the exchange rate?

There are two basic strategies that governments and central banks can adopt to engineer changes in rates in floating or hybrid regimes.

1. By buying and selling currencies in the forex market. For example, if the central bank wishes to engineer a depreciation in a currency it will use its own currency to purchase another currency, or several other currencies - releasing supply into the market. This may trigger a small fall in the exchange rate which may trigger other currency holders to sell. Once the desired rate is reached, the central bank will re-enter the market to buy its own currency, and halt further unwanted reductions.
2. Secondly, the central bank (let us say, the Bank of England) can adjust the interest rate to influence the demand for assets in its own country (the UK). For example, if the Bank of England wishes sterling (the GB pound) to appreciate, it will increase the Bank of England base interest rate, which will increase the return on holding assets in sterling. This increased demand for UK assets increases the demand for sterling, which, ceteris paribus, will then appreciate.

These two strategies can be operated in tandem to help engineer changes to keep a currency within an agreed band or range.

One danger with managed rates is that countries can deliberately engineer a fall in their currency to target the export market of a competitors. This can lead to retaliation and soured relationships.

Examples of exchange rate regimes

Summary of advantages and disadvantages of different exchange rate regimes

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What is the impact of exchange rate changes?

Changes in exchange rates can have a considerable impact on the rest of an economy:

		↑ An increase in the exchange rate	↓ A decrease in the exchange rate
	Growth	Harms exports (↓X), harms AD (↓AD) harms GDP (↓GDP)	Helps exports (↑X), stimulates AD (↑AD) increases GDP (↑GDP)
	Jobs	↓ GDP reduces demand for labour (↓E) (↑U)	↑GDP → increases demand for labour (↑E) (↓U)
	Prices	Cost push inflation reduced (↓P)	Cost push inflation  (↑P)
	Trade balance	Will worsen if Marshall-Learner satisfied	Will improve if Marshall-Learner satisfied

Read more on devaluation and the J-curve

Automatic adjustment

An important benefit of floating rates is that the current account of the balance of payments will move back towards equilibrium following a change in trade flows. This is because changes in imports and exports in one time period alter the exchange rate, which means that trade flows adjust in the future.

For example, assume the exchange rate between the US dollar and UK pound is in equilibrium at £1=$1.40, and that the quantity of pounds traded is £50bn. We can also assume that the current account is in balance, with the UK's imports and exports equaling £50bn (assuming imports and exports are the only elements of the balance of payments).

If there is now an increase in imports from the US, the supply of pounds will increase (to S¹) - given that UK traders must sell pounds to buy US dollars. The effect if to create a trade deficit of £20bn (with imports at £60bn, and exports at £40bn).

The effect of this is to push the value of the pound down to £1-$1.20, causing exports to increase to £50bn, and imports to fall to £50bn, re-establishing a current account balance.

Depreciation and the J-Curve

As with the balance of payments, a falling currency will stimulate exports and constrain imports. But this is likely only to happen after a time lag. For this to work, the famous Marshall-Lerner condition must be satisfied (where the sum of import ant export price elasticity is greater than 1.) But in the short run this is unlikely to be the case – hence the J-curve effect. The diagram shows that, at point a, the economy experiences a current account deficit.

A devaluation in 2017 would make the deficit worse (moves to point b) because both import and export demand is likely to be price inelastic. Only in the long run will the current account move towards a balance (at point c) as the Marshall-Lerner condition is satisfied after 2 or 3 years.

Read more on optimal currency areas

Questions on exchange rates

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