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Between 1995 and 1997 the effective exchange rate of the pound sterling appreciated by 20%. What factors might explain this increase in the value of the pound?

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Introduction

5. Between 1995 and 1997 the effective exchange rate of the pound sterling appreciated by 20%. (a) What factors might explain this increase in the value of the pound? There are several reasons that contribute to the appreciation of the pound. INTEREST RATES Interest rates have a large effect in a world where financial capital can move freely between countries. If for example the UK interest rates are high relative to elsewhere this attracts inflows of money into the UK seeking to take advantage of the high interest rates. This "interest differential" boosts the demand for the currency and can cause its value to rise. ECONOMIC GROWTH Countries experiencing a rapid economic growth often find that their exchange rate is strengthening. Traders in the currency markets may take the rapid growth to be a sign of general economic growth and "mark up" the value of the currency as a result. Also economies with strong "export-led" growth may see their currency's rise in value. Japan is a good example of this in recent years. The Euro was weak during the first six months of its existence in part because the financial markets were worried about the slow growth of the European economy and the persistently high level of unemployment. ...read more.

Middle

MARKET SPECULATORS Special factors (such as political events, changing commodity prices etc.) can have an effect on a currency. In addition the power of market speculators has grown. When speculators decide that a currency is going to fall in value, they sell that currency and buy ones they anticipate will rise in value. It is difficult for government's to offset the power of speculators because their reserves of foreign currencies are very small compared to daily turnover in the market. We saw in 1997 and 1998 speculative attacks on currencies in Asia and seven years ago, the pound was forced out of the European exchange rate mechanism because of speculative selling of the pound. (b) Examine the likely effects of this increase in the value of the pound on the UK economy Changes in the exchange rate can have a powerful effect on the economy - but these effects take time to show through. There are time lags between a rise or a fall in the exchange rate, and changes in variables such as inflation, GDP and exports & imports. ...read more.

Conclusion

The strength of sterling in the last five years is one of the factors highlighted when economists analyse the north-south economic divide in the UK Many business organisations have identified the strength of the exchange rate as a major economic problem over recent times. Economists working for the ITEM club argued in the summer of 2001 that the pound should be lower by at least 10% in order to prevent manufacturing industry falling into an economic slump. However it should be noted that business can adapt to a high exchange rate. There are ways in which industries can adjust to the competitive pressures that a strong pound imposes. Some of the options include: * Cutting export prices (lower profit margins) to maintain competitiveness and market share * Out-sourcing components and raw materials from overseas * Seeking productivity / efficiency gains to keep unit labour costs under control * Investing resources in new product lines where both domestic and overseas demand is more price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors are more important in securing orders. * Moving production overseas ...read more.

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