What are Exchange Rates?

The Exchange rate is the price of one currency against another currency on the foreign exchange market (FOREX). Currencies are continuously being traded on the FOREX, therefore the price of currencies are constantly fluctuating.

These fluctuations we often refer to as appreciations and depreciations, we will take a look at these concepts in these notes.

We look at exchange rates in the context of the macro economy because exchange rates effect the prices of exports and imports, this in turn affect aggregate demand (AD).

Appreciation of the Exchange Rate

Example of the exchange rate appreciation: Last week £1 = $2, This week £1 = $2.20

How does this effect the balance of payments?

Last week a good costing $10 required £5. This week the item costing $10 requires £4.54. The pound has appreciated against the dollar making imports from the USA cheaper and exports relatively more expensive.

An increase in imports and a decrease in exports will shift the AD inwards.

Depreciation of the Exchange Rate

Example of the exchange rate depreciation: Last week £1 = $2, This week £1 = $1.80

How does this effect the balance of payments?

Last week a good costing $10 required £5. This week the item costing $10 requires £5.50. The depreciation of the pound stirling against the dollar makes imports from the USA more expensive and exports relatively cheaper.

An increase in exports and decrease in imports will shift the AD curve outwards.

Factors Effecting the Exchange Rate

1) Monetary Policy / Interest Rates

Higher interest rates make deposits in the UK more attractive (“hot money flows”) this increases demand for pounds and causes an appreciation.


2) Inflation

Countries with lower inflation rates see exports increase thus demand for pounds increases and an appreciation in the value of their currency occurs.


3) Fiscal Policy / Government Intervention

Governments attempt to influence the value of their currency. For example, China has sought to keep its currency undervalued to make Chinese exports more competitive. They can do this by buying US dollar assets, which increases the value of the US dollar next to the Chinese Yuan.