Exchange Rate Fluctuations (Cambridge (CIE) O Level Economics)

Causes of Exchange Rate Fluctuations

• Numerous factors influence floating exchange rates, resulting in an appreciation or depreciation of a currency

1. Relative interest rates: influence the flow of hot money between countries. If the UK increases its interest rate, then demand for £'s by foreign investors increases and the £ appreciates. If the UK decreases its interest rate, then the supply of £'s increases as investors sell their £'s in favour of other currencies and the £ depreciates

2. Relative inflation rates: as inflation in the UK rises relative to other countries, its exports become more expensive so there is less demand for UK products by foreigners, which means there is less demand for £s and so the £ depreciates

3. Net investment: foreign direct investment (FDI) into the UK creates a demand for the £ which leads to the £ appreciating. FDI by UK firms abroad creates a supply of £'s which leads to the £ depreciating

4. The current account: UK exports have to be paid for in £'s. UK imports have to be paid for in local currencies, which requires £'s to be supplied to the forex market. Due to this, an increasing net exports will result in an appreciation of the £ and falling net exports will result in a depreciation of the £ 

5. Changes in tastes/preferences: As global demand for quinoa increased as it became fashionable, Bolivia's exports of quinoa increased dramatically which put upward pressure on their currency. Foreigners demanded the Boliviano in order to pay for the quinoa

6. Speculation: the vast majority of currency trades are speculative. Speculation occurs when traders buy a currency in the expectation that it will be worth more in the short to medium term, at which point they will sell it to realise a profit

7. Quantitative easing: involves increasing the money supply and much of the new supply is used to buy back gilts. Many of these gilts are owned by foreigners who then exchange the £s received for their own currency. The increase in the supply of £'s depreciates the £ 

8. MNCs: An increase in the number of MNCs globally will result in more money flows between countries, each of which influences exchange rates

Consequences of Foreign Exchange Rate Fluctuations

• Changes to exchange rates may have far-reaching impacts on an economy