2.4.4 Exchange rates

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    Exchange rates are the value of one currency expressed in terms of another. Appreciation is the rise in value of a currency whilst depreciation is a fall in value; both of these occur in a floating exchange rate system.

    Floating exchange rate – when the exchange rate is determined by the market forces of   supply and demand

    Fixed exchange rate – when one currency ties its value to another currency/commodity e.g.  the gold standard

    With the fixed exchange rate, devaluation is when the exchange rate is officially lowered (similar to depreciation) whilst revaluation is when the exchange rate is adjusted relative to a baseline (similar to appreciation).

    Depreciation of a currency makes it more price competitive in the export market and will increase sales revenue. However, if the goods are relatively price inelastic, a depreciation will not increase sales significantly. As for imports, they will become more expensive as raw materials will now cost more, which will either reduce profit margins or increase prices, the latter making them less competitive. If they have fixed contracts for imports, this will reduce some uncertainty in terms of production costs.

    Appreciation of a currency will have the opposite effect as UK exports will become more expensive for foreign countries. Imports will become cheaper as they will require less pounds to buy foreign currency to purchase raw materials. This decreases the costs of production and makes UK goods cheaper (mostly in the domestic market).

    Interpretation of effective exchange rates

    Effective exchange rate – strength of one currency compared to a basket of other currencies   using an index

    The weighting of each currency is dependent on how important trade between the country and its partners is. This makes it an accurate measure of competitiveness. This is a useful indicator of the relative strength of a currency. A rise in the index means that the purchasing power of that currency has risen relative to trading partners.

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