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THE EXCHANGE RATE
A fixed exchange rate is one where the price of one currency is
the same as the price of other currencies. However, if the price
comes under threat by market forces then the central bank will
either buy/sell the currency and/or change the interest rate.
A government can influence the value of a floating exchange rate
if it thinks it is rising too high, falling too low or is too unstable.
However, this is effectively changing the exchange rate from a
floating to a managed exchange rate - i.e. it becomes a "policy
instrument" (e.g. a government might undertake a devaluation of
its fixed exchange rate or encourage depreciation in a floating
exchange rate, in order to improve the current account, raise
output and reduce unemployment).
If a government wants to maintain an exchange rate at a certain
value then it may have to sacrifice other policy objectives (e.g. an
increase in interest rates may cause reduced output and higher
EXCHANGE RATE MOVEMENTS
An increase in the exchange rate will:
Cause an increase in the country's exports in terms of foreign
Reduce the price of imports in terms of the domestic currency.
The price of imported raw materials will fall reducing the costs of
production reduction in the price of imported finished products
Likewise domestic firms will be facing cheaper competition from abroad, and will be under pressure to cut
their own costs of production higher unemployment.
However a rise in the exchange rate will improve the terms of trade the sale of each export would allow
more imports to be purchased. That said, a change in prices will affect demand.
A decrease in the exchange rate will:
Make export prices cheaper in terms of foreign currencies;
Make import prices higher in terms of the domestic currency.
Initially a lower exchange rate will initially worsen a country's trade
position that is, until people start to find out about the better prices
and alter their spending plans. The situation where the trade position
worsens before improving is known as the J curve effect.
INTEREST RATES AND EXCHANGE RATES
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If a country's interest rates increase then it is likely that the exchange rate will also rise. This is
because a higher exchange rate usually results in an increase in demand and fall in supply of the
People from abroad will be more willing to buy pounds to put into UK banks, in order to take advantage of
the high returns. Likewise, fewer UK citizens will sell pounds to buy foreign currencies, to place into
foreign banks.…read more