How is the Exchange Rate Determined?

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How is the Exchange Rate Determined?

As you have probably worked out by now, virtually any market can be analysed using supply and demand curves, and the markets for currency are no different. Luckily, in terms of remembering the diagram, the supply curve has the normal upward sloping look about it, and the demand curve is a normal downward sloping curve.

Why is the demand curve downward sloping?

Have a look at the diagram below:

Demand curve

This is the standard price/quantity situation, except the 'price' is the price of the pound in terms of the dollar (i.e. the exchange rate of the pound against the dollar) and the 'quantity' is the quantity of pounds being demanded.

If the price of the pound in terms of dollars drops in value from $2 to $1, British exports in the USA will become much cheaper relative to the home-produced goods on offer. The demand for these British exports will rise in America, and the demand for pounds to buy these exports will also rise as a result. So at lower prices (or exchange rates) more pounds will be demanded, and vice versa.

Why is the supply curve upward sloping?

Supply curve

In the diagram above, the price of the pound in terms of dollars has risen from $1.50 to $2. This will make the price of imports from the USA fall and, assuming the price elasticity of demand for these American imports is greater than one, the amount of pounds that UK consumers will need to supply in order to buy the dollars to buy the goods will rise. So at higher prices (or exchange rates) more pounds will be supplied, and vice versa.

Putting demand and supply together

In the example, below, we shall be looking at what happens to the exchange rate when an American decides to buy a British made Rover car. There are two diagrams. One shows what happens to the price of the pound in terms of dollars, and the other shows what happens to the dollar in terms of the pound:

Putting demand and supply together

If an American buys a British Rover, there will be an increase in the demand curve for pounds. The demand curve will shift from D1 to D2. In order to buy these pounds the supply of dollars will have to rise. The supply curve in the second diagram shifts to the right from S1 to S2. In the first diagram, the 'price' of the pound rises from £1 = $1.50 to £1 = $1.60. In the second diagram, the 'price' of the dollar falls from $1 = £0.67 to $1 = £0.63.

Obviously, if the price of the pound in terms of dollars rises, the price of the dollar in terms of pounds must fall. Note that the prices used above were made up. It is very unlikely that the changes in demand and supply of pounds and dollars will cause the exchange rate to change by so much!

From this analysis, it follows that if the value of exports into the USA (from the UK) exceed the value of imports into the UK (from the USA) then the value of the pound in terms of dollars will rise and the value of the dollar in terms of pounds will fall. If the UK imports more than it exports (which is more usual) then the value of the pound will fall.

The supply and demand analysis above worked quite well in the days before the war and, to a certain extent, in the three decades afterwards. This was because there were tight capital controls, so most of the demand for foreign currencies was for the purposes of importing goods and services. Trade deficits would lead, eventually, to a fall in the exchange rate, and trade surpluses would cause the exchange rate to rise.

In the last twenty years, capital markets have been opened up; there are now very few controls on the flow of capital worldwide. In the UK, the controls on currencies were abolished in 1979; one of the first acts of the new Conservative government. This has created many more reasons to demand and supply currencies.

Foreign direct investment

The UK is the recipient of the second largest amount of capital from abroad for the purpose of direct investment. Foreign direct investment includes any investment in a business overseas to gain profit. It could also include the transfer of ownership of businesses across national boundaries. Examples include when Nissan built a factory in Sunderland, or when Marks & Spencer invested in new shops around the world.

The UK always used to invest more money abroad than foreigners invested in the UK. This has changed recently, with the net flow of money being into the UK. This means that the demand for pounds for this investment in the UK is higher than the demand for foreign currencies by UK businessmen investing abroad. This will cause the pound to rise in value. The diagrams above can be used to show this effect. The principle is exactly the same as when the demand for pounds to buy British goods out-strips the demand for foreign currencies to buy foreign imports of goods.

Portfolio investment

Portfolio investment refers to investment in things like shares and bonds. Again, much of this investment occurs across national boundaries nowadays. If a British resident decides to buy shares in an American company, this will cause a rise in the demand for dollars in the same way that the purchase of an American computer does. The standard supply and demand analysis can be used again.

Official reserves

Governments often attempt to influence the value of their currency. If the country in question is part of a fixed exchange rate system then it is imperative that they use some of their official reserves to buy the currency when it threatens to drop below the allowed bands, or sell the currency and buy the appropriate foreign currencies to stop it from rising too high.

But even nowadays, when the pound floats freely on the foreign exchange markets, the government may intervene if they feel that the market has taken the value of the pound too high (which crucifies exporters with very high export prices) or too low (which can be very inflationary through higher import prices).

It should be noted, though, that governments are powerless against the power of the foreign exchange markets if investors and speculators feel that a currency is fundamentally at the wrong level. The total foreign exchange reserves of all major countries added together are still dwarfed by the daily turnover of foreign exchange in the world's currency markets.

The UK government spent £7 billion in one day buying various European currencies (especially German marks) in an attempt to stop the pound from falling out of the Exchange Rate Mechanism (ERM) on the 16th September 1992. They even raised interest rates by 5% on the same day to try and persuade speculators to buy the pound. The traders just laughed and kept selling the pound. It was a sign of desperation and simply confirmed that they had been right all along, and that the pound was certain to fall out of the ERM.


This is easily the biggest cause of changes in exchange rates in today's world of global capitalism. Numerous people work in the foreign exchange markets around the world whose sole job is to make money by trying to predict the movements of currencies. The daily turnover of foreign exchange in the UK foreign exchange market (the biggest in the world) is now over $600 billion! Whilst not all of this trade is for speculation, the majority of it certainly is.

So why might a speculator believe that a currency would rise or fall in the future? Here are some of the issues involved.

Interest rate differentials

Differences in the interest rate of different countries help to explain the differences in exchange rates in the short and long term. Investors will move spare cash into the currency whose country has the highest real interest rate. Of course, it is easy to see which country has the highest interest rate, in real and nominal terms, so the short-term decisions are easy. To see how the currency might move in the long term, the speculator has to consider the likely future path of interest rates and inflation rates in the relevant countries. This leads us onto...

Inflation rates

As you can see above, inflation rates affect real interest rates. Over the long term, countries with higher inflation rates will see their currency drop in value, because their exports will become uncompetitive, reducing future demands for their currency.

But as we have already seen, currency transactions for trade form a tiny proportion of total currency transactions. Speculators are nervous of investing in currencies whose inflation rate is starting to rise. This may be suggesting that the economy is over-heating. As night follows day, recessions tend to follow booms in the economy. This leads us onto the third point.

The state of the economy

The exchange rate of an economy is, in a sense, its barometer. Generally, economies that are 'doing well' have relatively strong currencies. Economies that are failing will have relatively weak currencies.

The recent economic history of the UK is a classic example. Economic theory suggested that the value of the pound should have started to fall in the summer of 2000 as the trade deficit rose to record levels. The demand for the pound for UK exports was low relative to the demand for the currencies of the foreign imported goods that UK consumers were buying. In the 60s, this would have led to a 'sterling crisis' and the value of the pound would have dropped like a stone.

Today, speculators dominate the market for currencies. They don't care about a large trade deficit as long as they think it can be financed. The pound stayed strong because the speculators were confident that the trade deficit could be financed; the fundamental strength of the economy gave the UK a 'safe haven' status in the currency markets. Whilst the strength of the UK economy was attractive, its stability was paramount. This appeals to investors and speculators alike.