10.2 - Exchange Rates
The definition and impact of exchange rates
Exchange rates indicate how much of one currency can be obtained with another. They influence international trade by affecting the cost of goods and services bought or sold across borders.
Definitions related to exchange rates
- Exchange rate - The value of one currency expressed in terms of another, e.g., £1 might equal $1.30.
- Appreciation - When a currency's value rises relative to another, e.g., if £1 increases from $1.45 to $1.65, the pound has appreciated against the dollar.
- Depreciation - When a currency's value falls relative to another, e.g., if £1 decreases from $1.45 to $1.35, the pound has depreciated against the dollar.
- Strength of currency - A currency strengthens when it appreciates (becomes worth more of another currency) and weakens when it depreciates (becomes worth less of another currency).
Effects of exchange rate changes on imports and exports
Changes in exchange rates alter the competitiveness of goods in international markets, impacting businesses that trade abroad.
Impact of exchange rate appreciation
On UK exporters:
- When the pound appreciates (e.g., £1 rises from $1.45 to $1.65), UK goods become more expensive for overseas buyers.
- This can make products less competitive, potentially reducing sales volumes.
- Exporters may need to lower prices to sustain demand, which could decrease profit margins, or shift focus to the domestic market.
On UK importers:
- Appreciation makes imported goods cheaper in pound terms.
- This can enhance profitability, enabling businesses to allocate savings to other operations.
Impact of exchange rate depreciation
On UK exporters:
- When the pound depreciates (e.g., £1 falls from $1.45 to $1.35), UK goods become cheaper for overseas buyers.
- This improves competitiveness, potentially boosting demand.
- Exporters might maintain their domestic currency price to increase foreign sales or raise prices to improve profits without losing market share.
On UK importers:
- Depreciation makes imported goods more expensive.
- This can squeeze profit margins, prompting businesses to source from domestic suppliers or pass costs to customers through higher prices.
Worked example - Calculating import costs with exchange rate changes
A UK firm imports components from a US supplier at a cost of $4.20 per unit. Initially, the exchange rate is £1 = $1.30. Later, the rate changes to £1 = $1.55. Calculate the cost per unit in pounds for both exchange rates.
Step 1: Identify the values
- Cost in dollars = $4.20 per unit
- Initial exchange rate = £1 = $1.30
- New exchange rate = £1 = $1.55
Step 2: Calculate cost at initial exchange rate
Cost in pounds = $4.20 ÷ 1.30 = £3.23 per unit (approx.)
Step 3: Calculate cost at new exchange rate
Cost in pounds = $4.20 ÷ 1.55 = £2.71 per unit (approx.)
Step 4: Interpretation
The cost decreases from £3.23 to £2.71 per unit when the pound appreciates from $1.30 to $1.55, highlighting the advantage for importers.
How to convert between currencies using exchange rates
Currency conversion is essential for international transactions and involves straightforward calculations based on the exchange rate.
Converting to a foreign currency
For example, with an exchange rate of £1 = €1.15, to convert £50 to euros: £50 × 1.15 = €57.50
Converting to the base currency
For example, with £1 = €1.15, to convert €80.50 to pounds: €80.50 ÷ 1.15 = £70.00
For a given exchange rate, the amount in one currency will always be higher or lower than the equivalent in the other, depending on whether the rate is above or below 1.
Worked example - Converting between currencies
A UK business needs to convert £120 into US dollars at an exchange rate of £1 = $1.35. Later, it converts $108 back to pounds using the same rate. Calculate both amounts.
Step 1: Identify the values
- Amount to convert to dollars = £120
- Amount to convert to pounds = $108
- Exchange rate = £1 = $1.35
Step 2: Convert pounds to dollars
Amount in dollars = £120 × 1.35 = $162.00
Step 3: Convert dollars to pounds
Amount in pounds = $108 ÷ 1.35 = £80.00
How to compare exchange rates with currency indices
Currency indices offer a way to monitor and compare exchange rate fluctuations over time by standardising values against a base year.
Calculating currency index number
The base year is set at 100, allowing easy comparison of changes. Graphs of index numbers illustrate trends in appreciation or depreciation across currencies.
Interpreting the currency index number:
- Below 100 indicates depreciation since the base year.
- Above 100 indicates appreciation.
Calculating exchange rates from indices
For instance, if the base exchange rate for £1 to Japanese Yen (JPY) is 140 and the index number is 105, the exchange rate is (105/100) × 140 = 147.
Worked example - Calculating currency index numbers
In 2020, the base exchange rate for £1 to US dollar (USD) was 1.60. In 2023, the exchange rate dropped to 1.52. Calculate the currency index number for 2023 and interpret the change.
Step 1: Identify the values
- Base exchange rate (2020) = 1.60
- Current exchange rate (2023) = 1.52
Step 2: Apply the currency index formula
Step 3: Interpretation
An index number of 95 indicates that the pound depreciated by 5% (100 - 95 = 5) against the dollar from 2020 to 2023.