Exchange rates as well as the exchange rates market are perhaps some of the most important features of the modern world economy. Their influence on everyday economic activities, especially with respect to international trade, cannot be underestimated. A business dictionary defines an exchange rate as, “Price at which one country’s currency can be converted into another’s. …….. Most exchange rates float freely and change slightly each trading day; some rates are fixed and do not change as a result of market forces” Basically it is the price of one country’s money, in relation to another.
Today, most major economies operate using a flexible exchange rate system whilst a few operate on a fixed exchange rate system. These two systems are discussed in a bit more detail in the following lines. Fixed and floating exchange rate regimes A fixed exchange rate regime is, “System in which the value of a country’s currency, in relation to the value of other currencies, is maintained at a fixed conversion rate through government intervention. ” Government intervention in this case can come in the form of mostly monetary instruments or policies.
The graph below demonstrates a fixed exchange rate system: In a fixed exchange rate system, the government deliberately tries to influence the exchange rate. A higher amount of pounds in circulation for example means that the value of the pound will be lower against other currencies and vice versa. By tempering with interest rates, or issuing treasury bills and other monetary instruments etc, the government can influence the amount of pounds in circulation and hence the exchange rate. In the United Kingdom a floating exchange rate system is used.
In a floating exchange rate system, the exchange rate is determined by market forces. This is reiterated by an investment promotion website which defines it as , “Currency exchange rate which is determined by free market forces, rather than being fixed by a government. The market forces here is mainly in reference to a country’s exports and imports. Its balance of trade account as well as other factors. The graph below gives a brief description of how a floating exchange rate system works. ?
All things being equal, a floating rate exchange rate system creates equilibrium for the demand and supply of pounds in the exchange market. When the demand for pounds reduces shown by Q1 to Q2 maybe as a result of bad economic data coming from the UK that makes investors shun the British pound, the supply of pounds also decreases, as seen by a shift in the supply curve to the left. If inflation in the UK is lower as compared to that in its major trading partners, this translates to cheaper exports from the United Kingdom.
British products will be cheaper as compared to others, demand for them will increase and hence the value of the pound. On the other hand foreign good will be more expensive hence British citizens will spend less on imports thus supplying less pounds to the currence markkert. This translate to a stronger pound. If the Governor of the Bank England decides to reduce interest rates, this will make the United Kingdom a less lucrative destination to invest in. Thus investors will pull their funds away from the British money markets.
In doing so they increase the amount of pounds in the market, forcing the pound to depreciate. 3. Speculation In modern times this has become a very important factor. Trading in currencis has become a lucrative way of making money, as a result of the internet. The situation created is that there are just lots of people who are holding on to a lot of pounds for none other reason than just mere speculation. If speculator beleive that the pound is going to appreciate in future, they will buy lots of pounds from the foreign exchange market and this does have a tremendous effect on the market.
A stronger pound simply means that prices of imported goods are cheaper. This means that the price of imported raw materials to make Estee Lauder’s beauty products is lower. Thus cost of production will be very low. On the other hand however if Estee Lauder decides to export some of its products to Germany for example, the amount of sales will be low, because British goods will be more expensive for people using Euros. This situation can be reversed if we are talking of a weaker pound as compared to the euro.
However a strong pound helps keep a check on inflation ensuring economic stability and making sure the company finds strategies to remain competitive. Thus the study of the exchange rate markets is of mass importance and its influence on a company’s operations cannot be underestimated.
“Factors influencing exchange rate – Economics Help. ” Economics Help – Helping to Simplify Economics. 4 May 2009 http://www.thisismoney.co.uk/money/index.html
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