Mere speculation can cause an appreciation of a country’s currency. If speculators think that the value of a currency is about to rise, they will start buying that currency. This in turn will increase the demand and actually cause the currency to appreciate. 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. 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.
Official buying of the currency by the central bank also takes place. The government might be adopting a policy to raise the value of its own currency. Buying the currency will increase demand and raise the exchange rate.
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
The currency of country also appreciates if there is a fall in the supply of that currency. This fall in supply could be caused by a number of reasons.
A fall in the goods imported into the UK. domestic consumers and firms sell sterling to finance their purchase of imports or when they go overseas on holiday. When this activity decreases there will be a decrease in the supply as lesser pounds will be sold to buy foreign currency. A fall in imports may be due to reasons such as contracted consumer demand. Pessimism of a receding economy, which causes compulsion to save rather than spend on imported goods may be due to a gloomy outlook of the economy. Lack of job security and fall in wages or high taxation will cause a reduction in comsumer spending powers on imported goods. The price of imported goods might have risen.
A government concretionary fiscal policy might cause a country’s currency to appreciate. A fall in government spending or a rise in taxation (causing disposable incomes to fall) will lead to a fall in imports. Both factors will cause a fall in supply of the currency and cause it to appreciate.
Speculators who think that the sterling might rise will hold on to the currency and will refrain from selling to buy some other currency that they might have bought before. This will curtail supply and will cause the sterling to appreciate.
Any or a combination of a few of the above situations will lead to an appreciation of a country’s currency.
When the demand for sterling is high relative to supply, sterling goes up in value (an appreciation). The reverse is true when the market supply of pounds exceeds the demand. (Depreciation).
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 and a fall in the exchange rate, and changes in variables such as inflation, GDP and exports & imports. Much depends on the scale/size of any change in the exchange rate. Different factors affect the exchange rate in different intensities. Different factors will determine whether the change in the currency is short term or long term e.g. factors such as long term investment coming in the country will cause a long tem change while high interest rates will cause a short term change. The response of businesses and consumers to exchange rate fluctuations will also contribute to how long the exchange rate remains high.
(b)
In recent years the sterling exchange rate has risen appreciably against a range of other leading currencies - not least the Euro since its inception in January 1999. Who are the main gainers and losers from a rising exchange rate?
An appreciation of the exchange rate has economic consequences both in the short and long term. As the economy adjusts to a higher exchange rate, some of the main beneficiaries and losers start to emerge.
There will be both positive and negative effects on everything related to the exchange rates such as employment, inflation, the balance of payments and aggregate demand and supply.
Exchange rate and the balance of payments:
The terms of trade will improve when the currency of a county appreciate. When there is an appreciation of the exchange rate, the price index of another country will rise and likewise, the price of imports in local currency will fall. Assuming ceteris paribus the terms of trade will improve. This improvement in the terms of trade will have an effect on the balance of payments.
Depending on the price elasticity demand for exports and imports, an appreciation of the
Exchange rate will see a widening of the trade deficit. In the short run, as imports and exports are usually price inelastic, the inflow of money will cause the balance of payments to improve.
As import prices will fall it will become Cheaper for businesses to import capital goods, raw materials and components. Cheaper import prices may even cause an expansion of out-sourcing of inputs from overseas.
Fall in the relative price of imported goods and services will encourage a faster growth of import volumes if consumer demand is strong. This could be bad for the country in the long run as consumers may get dependent on imported goods, local production may go down and then when the exchange rate falls there might be a fall in living standards.
Increase in the relative prices of imports will cause a fall in the profitability of exporting overseas. Growth of exports is likely to slowdown. A loss of market share may occur and this loss of export market share may be difficult to recover.
When the prices of exports rise from P1 to P2 quantity demanded will fall less than proportionately because of price elasticity from Q1 to Q2. As F is bigger than H the export earnings of the foreign country to which UK exports will rise.
On the other hand when the prices of imports into the UK falls from P1 to P2, quantity demanded will rise less than proportionately, from Q1 to Q2. Area A is larger than B which shows that the import expenditure of the UK has fallen in sterling.
In the long run however an appreciation of a currency will cause a deterioration of the balance of trade and a loss for the country will occur because in the long run the price elasticities of both exports and imports will tend to become more elastic. And if the country does not have sufficient funds to cover the deficit, it will have to borrow and might become debt burdened.
Exchange rate and unemployment:
A higher exchange rate might threaten employment in industries open to international trade.
As the price of exports rises it will become Harder to export goods and services – fall in export orders might lead to plant closures, redundancies etc.
A fall in the relative price of imports will lead to a rise in import penetration into the domestic economy. This will squeeze domestic output and employment.
Some firms may respond to high exchange rate by seeking productivity improvements and this may lead to cutbacks in employment in some industries.
High exchange rate may dissuade some foreign firms from investing in the UK.
Multiplier effects will arise from a fall in aggregate demand. A trade deficit results in a net outflow of money. According to the kenesian model, this will cause a backward multiplier process. This will lead to a fall in national income and a fall in employment.
A fall in employment will obviously cause a serious fall in living standards.
Exchange rate and inflation:
An appreciation of the exchange rate helps to control cost and price inflation in the economy.
A fall in import prices means that it is cheaper to import raw materials, components, finished manufactured products leading to an outward shift in Short Run Aggregate Supply shown in diagram – this has a direct impact on the Retail Price Index
Tougher for domestic companies to compete with cheaper imports – lower profit margins as
businesses have to adjust (less pricing power in their markets)
Slower growth of exports (leading to a slowdown in aggregate demand – possibly the
emergence of a negative output gap where actual GDP < potential GDP)
A bigger trade deficit represents a net outflow of demand from the circular flow of income
and spending – leading to less demand-pull inflation
