How exchange rates are determined

Exchange rates represent the value of one currency in terms of another. These rates are primarily set by the interaction of supply and demand for a particular currency in foreign exchange markets.

Factors influencing demand for a currency

Demand arises when foreigners need the domestic currency for various reasons:

• Purchases of domestic exports by overseas customers, requiring them to buy the local currency.
• Spending by international tourists visiting the country.
• Investments from abroad attracted by favourable domestic interest rates.

Factors influencing supply of a currency

Supply increases when domestic residents exchange their currency for foreign ones:

• Local firms acquiring imported goods, needing foreign currency to pay suppliers.
• Residents travelling overseas and converting money for expenses.
• Domestic investors buying assets abroad, converting to the relevant foreign currency.

Exchange rate depreciation and appreciation

Changes in supply and demand lead to movements in exchange rates, affecting a currency's value relative to others.

Exchange rate depreciation

Depreciation happens when the supply of a currency outstrips demand, causing its value to drop. For example, if the British pound falls from €1.50 to €1.40 against the euro, it has depreciated.

Exchange rate appreciation

Appreciation occurs when demand for a currency exceeds supply, driving its value higher. For instance, if the British pound rises from €1.40 to €1.50 against the euro, it has appreciated.

Business winners and losers from exchange rate changes

Exchange rate fluctuations create varied impacts on businesses, depending on their reliance on imports, exports, or domestic markets.

Winners from exchange rate appreciation

• Importers - Businesses buying foreign raw materials benefit from lower costs in domestic currency terms. Firms importing finished products also pay less, improving margins.
• All businesses - May gain from lower overall inflation.

Losers from exchange rate appreciation

• Exporters - Companies selling goods abroad face higher prices for overseas buyers, reducing competitiveness and potentially sales.
• Domestic competitors facing imports - Firms facing imported competition suffer as foreign goods become cheaper locally.

Winners from exchange rate depreciation

• Exporters - Firms can lower prices in foreign markets to attract more customers, boosting sales.
• Domestic competitors - Local businesses face less pressure from expensive imports, protecting market share.

Losers from exchange rate depreciation

• Importers - Manufacturers relying on overseas components see higher costs. Retailers sourcing foreign goods face increased expenses, squeezing profits.

Government exchange rate policies

Governments typically prioritise stable exchange rates to support predictable trade and investment. However, they may intervene or allow changes to achieve specific economic goals.

Situations where governments may encourage exchange rate changes:

• Promoting depreciation to enhance the competitiveness of local industries in global markets.
• Allowing depreciation to counteract the effects of high domestic inflation on export prices.
• Supporting appreciation to improve citizens' purchasing power abroad and help control inflation.

Benefits and limitations of common currencies

A common currency, such as the euro in parts of Europe, involves multiple countries sharing the same money system. This can simplify trade but also introduces constraints on national policies.

Benefits of adopting a common currency

• Removes exchange rate volatility between member nations, providing stability.
• Stabilises costs for imported resources and components from within the group.
• Ensures consistent export pricing, aiding planning.
• Eliminates uncertainty in profits from cross-border trade or investments.
• Lowers transaction costs for businesses operating across members.
• Attracts investment from outside the group due to reduced currency risks.

Limitations of adopting a common currency

• Countries lose the ability to set their own interest rates independently.
• May result in harmonised tax systems, limiting fiscal autonomy.
• Prevents using depreciation as a tool to improve competitiveness during economic downturns.

Non-price factors in international competitiveness

Beyond exchange rates, businesses can enhance their global standing through factors unrelated to pricing. These elements focus on adding value and building loyalty.

Key non-price factors that boost competitiveness:

• Innovative product design - Creating unique items, like advanced fitness trackers, that appeal to buyers even at higher prices.
• Superior quality and reliability - Building a reputation for durable goods, such as high-end vehicles known for long-term performance.
• Strong marketing and distribution - Achieving global brand awareness through effective advertising and widespread availability, as seen in international cafe chains.
• Excellent after-sales support - Offering comprehensive warranties or maintenance services to reassure customers.
• Investment in workforce and technology - Training staff and adopting modern equipment to increase efficiency, flexibility, and output quality.