The Exchange Rate

The exchange rate is fundamentally set by demand and supply. If there is high demand (lots of people want to convert their currency for the pound) for the pound but low supply then the value of the pound will increase. Conversely if there is low demand but high supply of the pound then it will weaken.

A strong (high) pound makes imports cheaper and exports more expensive. This will encourage people to buy cheaper imports which may hit the domestic market and would hit the profits of the exporters.

A weak pound makes exports cheaper abroad and so should encourage foreign consumers to purchase them. However UK exports are generally price inelastic and therefore this may not have a large impact. A weaker pound should also make imports more expensive. This means that British-produced goods are cheaper and so should sell more. This may lead to UK firms increasing output for the domestic market providing a boost to AD. However in the short-run with firms unwilling to invest this may not happen. It is more likely that there would be cost-push inflation from the rise in import prices.

As always there is a multiplier effect present. If the pound was to weaken then exports are likely to increase, this would boost AD. However the multiplier effect would mean any injections would be multiplied and should have a greater effect on the UK economy.

A weak pound would imply that foreign investment should grow. This is because they get more sterling for a unit of their currency therefore making it cheaper to invest. By doing so they would create jobs and investment in the UK. They might set up manufacturing in order to export to European countries more cheaply than they could do from their home market. However this is unlikely due to the Eurozone crisis and a fall in consumption, so foreign investment may not be that high due to business uncertainty. There may also be better returns to be had in growing markets such as the BRICs.

Although foreign investment may not be increasing hot money in the UK is. Hot money is money that is saved in UK banks and assets in the short term. Foreign firms may take advantage of the weak pound in order to put money in UK banks to make a return. Hot money greatly exacerbates the effect of the exchange rate as such vast amounts of money are transported thus greatly affecting the demand and supply mechanism. If foreign firms send a lot of hot money to the UK then demand for sterling will increase, if this isn’t met by supply then the value of the pound will increase. This may have negative effects for our exports. Therefore by having a low base rate (and thus interest rates) it may reduce the amount of hot money flowing into the country.

Page last updated on 20/10/13