Exchange Rates
Definition: "Exchange Rate" is the price of one country’s currency expressed in terms of another.
Fixed Exchange Rates
Are not permitted to respond to changes in demand for currencies. The rate is controlled by central bank intervention. If the pound came under selling pressure, the market reaction would be a fall in the exchange rate. Under a fixed system the Bank of England would step in to buy pounds with foreign currency to make up for the shortfall in demand.
Floating Exchange Rate
A currency which responds to supply and demand on the foreign exchange markets without central bank intervention.
It may still be managed by the central bank to reduce day-to-day fluctuations.
It will depreciate if demand for the currency falls or if supply rises and appreciate if demand rises or supply falls.
Pros
- Requires no foreign currency reserves
- The exchange rate adapts to changes in trade patterns
- Reflects market forces
- Accepts that “you can’t buck the market” (Mrs Thatcher)
Cons
- Firms cannot predict future rates, adding to uncertainty
- Leaves the international competitiveness of a country’s goods to a market that is often affected by speculative money flows; these may have little to do with the underlying state of the economy and its balance of payments
Exchange Rate Mechanism (ERM)
Countries belonging to the ERM agree to keep their exchange rates within a range of values known as currency bands.
Factors That Affect The Exchange Rate
- Interest rates
- Speculation
- Investment and capital flows
- Supply and demand
- Competitiveness
|