What is an exchange rate and why is it important?
Here, we talk about exchange rates, why they are important and how they impact us personally as well as how they impact the UK economy. It’s useful to know about exchange rates as you prepare for any of the CII’s investment-related exams, such as AF4, J10, J12, or R02.
What is an exchange rate?
An exchange rate can best be described as the amount of money, in one currency, which can be exchanged for a different currency. In the UK, the euro exchange rate tells us the number of euros that one pound can buy.
Today one pound will buy 1.19 euros. Very simply, this means that every £100 we plan to spend on holiday in France (for example) will buy 119 euros and if someone from, say, France came to the UK they would have to pay 119 euros to get £100. (In reality, a dealer would make a profit which would affect these figures). Tomorrow, the exchange rate might be something different; the price of a currency is determined by demand and supply just like the price of a share.
Currencies are traded every day with traders in the foreign exchange working for businesses and banks. Exchange rates can change for a number of reasons; if interest rates increase in the UK, then foreign investors are likely to want to invest in UK banks and to do that, they will need to convert their own currency to pounds. If the demand for pounds increases, then the exchange rate of the pound would equally increase, and it will be described as the pound strengthening, meaning a pound will buy more of a foreign currency. When the pound falls in value, then it is said to be weakening.
Why are exchange rates important?
Exchange rates are important to us when we go on holiday, but they are also very important for businesses that import and export goods and services.
If the pound appreciates, this makes imports into the UK cheaper which in turn stimulates demand from the UK consumer. However, it will also make UK exports more expensive abroad leading to lower demand.
If the pound starts to de-value, then UK exports become more competitive but imports become more expensive.Exchange rates are important to us when we go on holiday, but they are also very important for businesses that import and export goods and services. Click To Tweet
What does it all mean?
So what does it all mean for us when we go on holiday?
Let’s assume £1 used to buy $2 but today it only buys $1.55. If we go to America for our holiday, then something that cost $10 used to cost us £5 but now that the pound has depreciated against the dollar, the item that cost $10 now costs us £6.45. This has various effects; it could stop us from going to America for our holiday, it will certainly make American imports more costly so we may stop importing and as it will be cheaper for Americans to buy UK goods and services, UK exports should in theory increase, which in turn should improve the UK’s growth.
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