Factors Affecting Currency Exchange Rates

Why Currency Exchange Rates Change

If our currency is demanded (for example, because our products are demanded), the price of our currency would increase unless we increase the money supply. Conversely, if, for example, people hold assets in our currency but want to sell them, this would lead to depreciation.

Interest rate is the price of our money, because we sell bonds that yield a certain benefit. If we increase the interest rate, we make the bond more attractive. People would invest money in these bonds, and less money would circulate in the economy.

This internal use of interest rates to control inflation also has external consequences. High interest rates make bonds more attractive to foreign investors who would want to buy Euros (or the local currency) to purchase our bonds. That would appreciate our currency. Conversely, we can depreciate the currency with low interest rates.

If public spending increases, the economy heats up, demand increases, and more money is demanded. If the central bank is not issuing more money (creating scarcity), the price of the money increases, which, as we have seen, leads to currency appreciation.

Major Factors Influencing Exchange Rates

• Economic Competitiveness

  If US businesses become relatively more competitive, there would be greater demand for American goods. This increase in demand for US goods would cause an appreciation (increase in value) of the dollar.

• Market Confidence

  However, 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.

• Inflation Differences

  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 fewer imports.

  • Therefore, countries with lower inflation rates tend to see an appreciation in the value of their currency.

• Interest Rate Policy

  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. This is known as “hot money flows” and is an important short-run factor in determining the value of a currency.

  • Higher interest rates cause an appreciation.
  • Cutting interest rates tends to cause a depreciation.

• Current Account Balance

  A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial/capital account, then this is acceptable. But a country which struggles to attract enough capital inflows to finance a current account deficit will see a depreciation in the currency.

Consequences of Currency Depreciation

If the pound depreciates:

• Exports become more competitive, increasing demand for exports.
• Imports become more expensive, leading to lower demand for imports.
• A depreciation will tend to increase economic growth but also cause inflation.