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What is an exchange rate and why is it important?

What is an exchange rate and why is it important?

As many of us plan our well-earned summer break in far-flung places or not-so-far-flung, one of the things on our holiday list will be spending money. And if we are lucky enough to be leaving the UK in search for sun, then it will be spending money in another currency we will need. It got us thinking about exchange rates, so we wrote this article to examine them further.

There has been a lot in the news about the strength of the pound against the euro, so what is an exchange rate? And what do the terms ‘strong against the pound’ and ‘weak against the pound’ actually mean?

What is an exchange rate?

An exchange rate can best be described as the amount of money, in one currency, which has to be exchanged for a different currency.

For example, if today one pound buys 1.14 euros, very simply, this means that for every 100 pounds we plan to spend on holiday in France, it will buy 114 euros. If someone from France came to the UK, they would have to pay 114 euros for 100 pounds. (In reality, a dealer would make a profit which would affect these figures).   Tomorrow the exchange rate might be something different – the price of 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.

 

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Why are exchange rates important?

Exchange rates are not only important to us when we go on holiday, but they are massively 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.

So what does it all mean for us when we go on holiday and are we an import or an export?!

Exchange Rate Example

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 costs $10 used to cost us £5, but now that the pound has depreciated against the dollar, the thing that costs $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;
  • 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.

Over to You…

And so what is the answer to the question: when we go overseas on holiday and buy the services of the other country and make payments to them – do we represent an export or an import?

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