Shifts in demand and supply move the rate
- A floating rate only changes when the demand curve or the supply curve for the currency shifts, so every explanation has to name one of them.
- A worked analysis therefore runs in four steps: the cause, who now wants or no longer wants pounds, the curve that shifts and its direction, and the new equilibrium rate.
- The causes fall into two families, money moving to pay for trade and money moving to be invested, and the second family is by far the larger and the faster.
Trade flows shift both curves at once
- When foreign buyers want more UK exports they need more pounds to pay for them, so demand for pounds shifts right and the pound tends to rise.
- When UK buyers want more imports they offer more pounds to obtain foreign currency, so supply of pounds shifts right and the pound tends to fall.
Interest rates pull money across borders
- Money placed in a UK bank or in UK government debt earns the UK interest rate, and savers everywhere compare that return with what the same money could earn abroad.
- If the Bank of England raises rates while rates elsewhere stand still, foreign savers want UK accounts more, and must buy pounds to access them, so demand for pounds shifts right and the pound appreciates.
- It is the relative rate that decides this, so a UK rate that looks high attracts money only while rates abroad are lower, and repels it the moment they are higher.
How the Bank of England chooses interest rates, and what else it is trying to achieve when it does, is covered in 3.6.1.
Relative inflation changes what a currency buys
- If UK prices rise faster than prices in the countries the UK trades with, UK products drift out of line with foreign ones before the exchange rate has moved at all.
- Foreign buyers switch away from the dearer UK goods, so the demand for pounds falls, while UK buyers switch towards the cheaper foreign goods, so the supply of pounds rises.
Investment and confidence move it fastest
- Money moved for investment is far larger and far quicker than money moved for trade, which is why a rate can swing sharply on a day when the trade figures have not changed at all.
- Underneath all of this sits confidence: investors hold pounds only while they believe UK assets are worth holding, and when that belief goes they sell the assets and then sell the pounds.
Example
- On 26 September 2022 the pound reached about 1.035 dollars, the lowest level against the dollar ever recorded.
- The fall came after a government mini-budget announcing large unfunded tax cuts, which caused a sharp loss of confidence in UK assets.
- Holders sold those assets and then sold the pounds the sales released, so supply of pounds rose and demand for them fell at the same moment.
- No export order or import bill changed in those few days, which shows that confidence alone can move a floating rate further and faster than trade can.
Exam technique
- Name the curve that shifts and its direction before saying what happens to the rate, because a rise in the demand for pounds is the reason the pound rises and is not the same statement.
- Where a factor is described as high or low, ask high compared with what: interest rates and inflation only move a currency when they are out of line with other countries.
Self review
- Which curve shifts, and in which direction, when foreign demand for UK exports rises?
- Why does a rise in UK interest rates tend to strengthen the pound?
- Why is it relative inflation rather than UK inflation that matters?
- How can an expectation that the pound will fall help to make it fall?
- What happened to the pound on 26 September 2022, and why?
