Exchange Rates

Exchange Rates

1. The Foreign Exchange Market - is the money market on which international currencies are traded

2. Prices are determined by supply and demand

   • Businessmen wishing to import goods will sell sterling in order to buy currency with which to pay the supplier in another country
   • Tourists coming in to the UK will sell their own currency in order to buy sterling

3. In any given period of time the factors wgich determine the demand and supply for foreign exchange rate are those which are represented in the balance of payments account

   • The demand for foreign exchange arises as a result of imports of goods and services, outflows of UK capital in the form of overseas investment and financial transactions by banks on behalf of their clients

4. Definitions

   • Nominal Exchange Rate- rate of exchange for any one currency as quoted against any other currency. It is therefore a bilateral (two-country) exchange rate
     • A fall in these NER for sterling since 2007 in particular is helping to make UK exports to these countries cheaper and imports dearer (in sterling)
   • Effective Exchange Rate - a measure that takes into account the fact that sterling varies differently against each of the other currencies. calculated as a weighted average.
   • Real Exchange Rate - designed to measure the rate at which home goods exchange for goods from other countries, rather than the rate at which the currencies themselves are traded. It is thus essentially a measure of competiveness

5. Exchange Rates and the balance of trade.

   • Traditional Approach sees the ER simply as the price which brings into equilibrium the supply and demand for currency arising from trade in goods and services and from capital transactions

6. Marshall- Lerner Condition: show the conditions under which a change in the exchange rate of a country's currency leads to an improvement or worsening of a country's balance of payments

7. Purchasing Power Parity: an economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currencies purchasing power