• The value of the currency is determined in the foreign exchange market where billions of $s of currencies are traded every hour.
• The main traders are businesses, international investors and governments
• London is the biggest centre of foreign exchange trading.

How does a change in the exchange rate influence the economy?

• Changes in the exchange rate can have powerful effects on the macro-economy affecting variables such as the demand for exports and imports; real GDP growth, inflation, business profits and jobs
• As with most variables in economics, there are time lags involved. The impact of movements in currencies on the economy depends in part on:

1. The scale of any change in the exchange rate i.e. a 5%, 10% or even larger movement
2. Whether the change in the currency is short-term or long-term – i.e. is the change in the exchange rate temporary or likely to persist for some time?
3. How businesses and consumers respond to exchange rate fluctuations – price elasticity of demand is important here i.e. will there be a large change in demand for exports and imports?
4. The size of any multiplier and accelerator effects
5. When the currency movement takes place – i.e. at which point of an economic cycle

How can changes in the exchange rate affect the rate of inflation?

The exchange rate affects the rate of inflation in a number of direct and indirect ways:

• 1.Changes in the prices of imports – this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the sterling price of imported consumer goods and durables, raw materials and capital goods.
• 2.Commodity prices and the CAP: Many commodities are priced in US dollars – so a change in the sterling-dollar exchange rate has a direct impact on the UK price of commodities such as foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.
• 3.Changes in the growth of UK exports: A higher exchange rate makes it harder to sell overseas because of a rise in relative UK prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels.

Bank of England research suggests that a10% depreciation in the exchange rate can add up to 3% to the level of consumer prices three years after the initial change in the exchange rate. But the impact on inflation of a change in the exchange rate depends on what else is going on in the economy. For example a lower pound is unlikely to have the same inflationary effects during a recession. 

Evaluation points on the effects of exchange rate changes

Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris paribus – all other factors held constant – which of course is highly unlikely to be the case

• Counter-balancing use of fiscal and monetary policy: For example the government can alter fiscal policy to manage AD
• Time lags – it takes time for demand for exports and imports to change following a movement in the currency. Businesses need to have the capacity and access to credit to expand their production.
• Low price elasticity of demand: In the short term, the effects of exchange rates on export and import demand tends to be low because of low price elasticity of demand
• Business response to the challenge of a high exchange rate: Businesses can and do adapt to a high exchange rate. There are several ways in which industries can adjust to the competitive pressures that a strong pound imposes. Some of the options include:
• a) Cutting their export prices when selling in overseas markets and therefore accepting lower profit margins to maintain competitiveness and market share
• b) Out-sourcing components from overseas to keep production costs down
• c) Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps trying to negotiate a reduction in pay levels
• d) Investing extra resources in new product lines where demand is price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors such as product quality, design and effective marketing are as important in securing orders as the actual price