Exchange Rates

Question 1

What happens to exchange rates when supply and demand increases in a country

Answer 1

As demand for the goods of a country increase, so people will want to buy the currency of that country so that they can buy the goods. For instance, if the USA were producing goods that everyone globally wanted to buy, then everyone would want
to get US Dollars in order to be able to make the purchase. This would mean that demand for Dollars increased and so the value of Dollars would increase, ‘strengthening’ the Dollar against other currencies.

Equally, where a country has high interest rates, investing in deposits in that country become more attractive and demand for the currency to make deposits will increase.
Again, this will strengthen the currency against other currencies.

Question 2

What happens to exchange rates when supply and demand decreases changes in a country

Answer 2

In times of low interest rates and poor demand for goods, the currency can weaken. This is also true where, for
instance, demand for overseas goods within a country is high. If everyone in the UK were keen to buy from overseas and people from overseas were not buying UK goods, then
there would be more people looking to get rid of sterling than buy it and its value would fall.

Question 3

How did the UK referendum vote lead to a fall in the value of sterling against the dollar and Euro?

Answer 3

This was because the instability in the UK made the Pound less attractive – there was more concern over the financial future
of the country. As fewer people wanted to get their hands on Sterling, demand fell and the price fell relative to other currencies. Whilst this is bad news for those people who buy goods from the USA (and also bad news because oil is priced in Dollars) because £1 now buys you less $, therefore
imports are dearer.

Question 4

A good acronym is SPICED (exchange rate £)

Answer 4

Strong Pound Imports Cheaper
Exports Dearer.

Question 5

Describe a fixed exchange rate

Answer 5

When exchange rates are fixed to each set by the government. An example is the European Exchange Rate Mechanism (ERM). The UK left the ERM in September 1992
and now has a floating exchange rate.

Question 6

Describe a floating exchange rate

Answer 6

Exchange rates are dictated by the supply and demand of the currency on the foreign exchange market.

Question 7

What happens to the rate of inflation when the pound strengthens

Answer 7

Falls, due to cheaper pr ices for imported goods

Question 8

What happens to the rate of inflation when the pound weakens

Answer 8

Increases, due to rising prices for imported goods

Question 9

What happens to interest rates when the pound strengthens

Answer 9

Pressure to reduce interest rates to combat effects of low inflation

Question 10

What happens to interest rates when the pound weakens

Answer 10

Pressure to increase interest rates to dampen spending and encourage spending

Question 11

What happens to the profitability on UK exports when the pound strengthens

Answer 11

Falls
Becomes more expensive to buy UK produced goods abroad, so demand falls

Question 12

What happens to the profitability on UK exports when the pound weakens

Answer 12

Rises
UK produced goods will reduce in price, which will increase the demand for those goods abroad

Question 13

What happens to the share price of major UK exporters when the pound strengthens

Answer 13

Falls
The fall in demand/profitability will drive the share price of UK exporters down

Question 14

What happens to the share price of major UK exporters when the pound weakens

Answer 14

Rises
The increase in demand/profitability will drive the share price of UK exporters up

Question 15

What happens to the VALUE OF PROFITS EARNED OVERSEAS BY UK COMPANIES
(WHEN CONVERTED BACK)
when the pound strengthens

Answer 15

Falls
If the pound rises against other currencies, i t will cost more to buy back £ sterling on
conversion

Question 16

What happens to the VALUE OF PROFITS EARNED OVERSEAS BY UK COMPANIES
(WHEN CONVERTED BACK)
when the pound weakens

Answer 16

Rises
If the pound falls against other currencies, it will cost less to buy back £ sterling on conversion

Question 17

Which firms benefit when the pound strengthens

Answer 17

Importers

Question 18

Which firms benefit when the pound weakens

Answer 18

Exporters

Question 19

ABC Ltd is a UK based company that exports goods to XYZ Ltd, a company based in the US. Let us assume the current exchange rate is £1:$1.50, meaning that for every £1, you can buy $1.50 in US currency.

ABC Ltd will soon sell £1,000,000 worth of goods to XYZ Ltd. To purchase £ sterling to complete this purchase, it will cost XYZ Ltd $1,500,000.

What happens if the exchange rate rises to £1:$2?

Answer 19

In this scenario, to purchase £1,000,000 it would now cost XYZ Ltd $2,000,000 to complete the transaction (an increase of 33%). There is a strong chance that XYZ Ltd would find this unattractive and walk away from the deal, and avoid trading with UK based exporters. This would affect the
demand for ABC Ltd’s goods in the US, which would impact profitability and
share price.

Question 20

ABC Ltd is a UK based company that exports goods to XYZ Ltd, a company based in the US. Let us assume the current exchange rate is £1:$1.50, meaning that for every £1, you can buy $1.50 in US currency.

ABC Ltd will soon sell £1,000,000 worth of goods to XYZ Ltd. To purchase £ sterling to complete this purchase, it will cost XYZ Ltd $1,500,000.

What happens if the exchange rate falls to £1:$1?

Answer 20

Here we achieve exchange rate parity, the point where two currencies share the same value. To purchase £1,000,000, it would no cost XYZ Ltd $1,000,000 to complete the transaction (a fall of 33%). This makes the deal very attractive for XYZ Ltd and they may choose to buy more from ABC Ltd
while the exchange rate is low. This would increase the demand for ABC Ltd’s goods in the US, which would have a positive impact on profitability and share price

Question 21

Describe the impact on the pound of the announcement of Brexit in 2016 and the
UK’s subsequent departure from the European Union (10 marks)

Answer 21

The announcement that the UK was due to leave the EU led to an initial large drop in the value of the pound
And a limited recovery since
This has led to foreign goods and services becoming more expensive for UK residents
Meaning an increase in the cost of living
And higher levels of inflation
Due to the UK’s reliance on foreign imports However, UK exports have become cheaper to overseas businesses Which has positive consequences for the UK’s trade deficit and Aggregate economic growth Post-Brexit trade frictions continue to make the future of the pound’s strength uncertain