Econ 4 June 2011 Essay (11)- Exchange Rates Question

11) Explain the factors which many lead to a rise in the exchange rate of a currency within a floating exchange rate system 

Define Exchange Rate – The exchange rate between two currencies is the price of one in terms of the other for example the price of a dollar($) expressed in sterling (£) is 50p the rate exchange or £1=$2 

What factors can affect the rise for the exchange rate:

Inflation Rate: If our inflation rate is low compared to other countries meaning our prices of our goods and services are not rising as fast as other countries. This would mean our prices for domestic goods would be lower and therefore more price competitive. Therefore people outside from the UK could demand more Pound Sterling in order to buy the UK goods. This would cause our sterling to increase in value- therefore appreciate.

Interest Rate: If the UK had a high interest rate- the cost of borrowing or the incentive to save this would mean that foreign people would tend to want to store their money in the UK Banks. Therefore demanding more UK Strerling as they will get a better return for their savings. This would also cause the pound to appreciate.

Speculation – Speculation is where people buy currencies in the hope in the future they will rise. So if speculators see the the Pound Sterling will rise in the future it will anticipate and buy more pound sterling. Therefore the demand for pound sterling will rise; hence the value and speculators have made money out of this. Showing it is not all about economic fundamentals like inflation but could be just the financial markets effecting it.

Change in competitiveness–  This shows similar factors to inflation rate however if the UK goods have improved in quality and become more attractive this would attract the foreign countries to buy their goods. Therefore there be more demand for pound sterling leading to an appreciation. 

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