THE

DETERMINATION OF
EXCHANGE RATES
 Overview
1. Ex. Rate determined by D + S on
foreign exchange market.
2. D + S affected by price itself (i.e. the
current Ex. rate) but also by
exogenous factors.
3. E Rate affects the major economic
indicators.
4. Governments may intervene to affect
the Ex. Rate.
 Demand for A Currency
• Comes from overseas groups / individuals who want
to convert their currency into pounds.
• Can you think of some reasons why they may want
to do this?
1. Purchase UK goods and services
2. Tourism in the UK
3. Direct investment in the UK
4. Portfolio investment in UK businesses / government
bonds
5. Speculative investment in sterling
 Demand factors 2 – Exogenous
Factors
• These will shift the demand curve inward and outward.
• Should be divided into trade / investment factors.
• Trade Factors
1. Change in price of g + s other than from ex rate.
2. Improvement non-price factors.
3. Tastes.
• Investment Factors
1. Interest rates.
2. Economic situation.
3. Rate of return on investment.
4. Future expectations of changes in ex rate.
 Supply of A Currency
• Comes from home groups / individuals who want to
convert their pounds into other currencies.
• How does this form of supply differ from that usually
found in a market?
• Factors of supply are a “Mirror Image” of demand.
• Upward sloping supply curve since increase in £
value increases purchasing power, meaning more
convert their pounds.
 £ in A Shift in Demand
$ Ex.
Rate
S £1

$2.25

$2

D £2

D £1
Q
Q1 Q2
 Activity
• Sketch the Following Situations on S+D Diagrams:

1. An improvement in the reputation of UK goods.

2. More UK people wish to go abroad on holiday.
3. UK labour productivity increases.
4. The Sterling exchange rate is expected to fall in
the near future.
 Impact of Ex Rate Changes On
Macro Variables
FALL IN EX RATE RISE IN EX RATE
Exports

Imports

Unemployment

Inflation

Current account
(Marshall Lerner >1)
Current account
(Marshall Lerner <1)
 Government Intervention In The
Foreign Exchange Market
• Why?
1. Stability
2. Reduce ex rate
3. Raise ex rate

• How?
• Gold / currency reserves.

• Successful?
• Black Wednesday 16/09/92 – loss of £3.4 billion.