Exchange Rates Summary

Main Factors that Influence Exchange Rates

Exchange rates are determined by supply and demand. For example, if there was greater demand for American goods then there would tend to be an appreciation (increase in value) of the dollar. If markets were worried about the future of the US economy, they would tend to sell dollars, leading to a fall in the value of the dollar.

1. Inflation- If inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also foreign goods will be less competitive and so UK citizens will buy less imports.
Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency.

2. Interest Rates: If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK. You will get a better rate of return from saving in UK banks, Therefore demand for Sterling will rise. Higher interest rates cause an appreciation. This is known as “hot money flows” and is an important short run factor in determining the value of a currency.

3. Speculation: If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation.

4. Change in Competitiveness: If British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound. This is similar factor to low inflation.

5. Relative strength of other currencies: In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose...