Exchange rate
Definition
Exchange rate: the price of one currency expressed in terms of another, set by the demand for and supply of that currency in the foreign exchange market.
- It shows how much foreign currency one unit of the domestic currency buys, for example £1 = $1.40.
- That single price then fixes the relative prices of every UK export and import, so it links the domestic economy to the rest of the world.
Key Idea
- The exchange rate is simply a price, but the good being priced is money itself.
- Because it sets export and import prices, it shapes a country's competitiveness and its inflation.
Ways to quote a rate
Definition
Bilateral exchange rate: the value of one currency against a single other currency, such as £1 = $1.40.
- A rate can be quoted in either direction, as $ per one pound or as £ per one dollar.
- The two directions are reciprocals, so if £1 = $1.40 then $1 buys about £0.71.
- The distinction between nominal and real rates, and trade-weighted (effective) rates, is developed at A Level (Cambridge 9708 11.2.1).
Example
- Take a quote of £1 = $1.40 and find the reverse quote.
- So $1 buys about £0.71, the reciprocal of the first quote.
- A UK good priced at £100 therefore costs a US buyer £100 × 1.40 = $140.
- One quoted price fixes the price of every traded good across the two currencies.
Note
- A stronger £ makes imports cheaper but UK exports dearer abroad.
- A weaker £ helps exporters but raises the price of imports.
- Whether a weaker £ improves the current account depends on how elastic demand for exports and imports is.
Why it matters
- It determines how competitive UK exports are abroad, because it sets their foreign-currency price.
- It affects the price of imported goods and so feeds into domestic prices and inflation.
- It therefore links closely to the current account of the balance of payments.
Exam technique
- Define the exchange rate as the price of one currency in terms of another.
- Show how it sets export and import prices, using a £/$ figure.
- Link a movement in the rate to competitiveness and inflation.
Common Mistake
- Do not describe a stronger currency as always good.
- It helps importers and consumers but hurts exporters.
Self review
- Define the exchange rate.
- In which market is the exchange rate determined?
- What does a bilateral exchange rate show?
- If £1 = $1.40, roughly how many pounds does $1 buy?
- Why does the exchange rate matter for inflation?
