An exchange rate is the price of one currency in terms of another, for example £1 = $1.25. When you buy something from abroad, or travel, you must swap your money into another currency at this rate.
Reading an exchange rate
If £1 = $1.25, then to find the dollar value of pounds you multiply by 1.25. To find the pound value of dollars you divide by 1.25.
- £40 in dollars: 40 x 1.25 = $50.
- $100 in pounds: 100 / 1.25 = £80.
Why exchange rates change
In a floating system the rate is set by the demand for and supply of a currency. The pound tends to rise when:
- foreigners want more British exports (they must buy pounds to pay);
- foreigners invest more in Britain;
- interest rates rise, attracting savers who want to hold pounds.
The pound tends to fall when the opposite happens, for example when Britons buy more imports and sell pounds to get foreign currency.
Appreciation and depreciation
An appreciation is a rise in the currency's value; a depreciation is a fall.
| Change | Exports | Imports |
|---|---|---|
| Currency rises (appreciates) | Dearer abroad | Cheaper at home |
| Currency falls (depreciates) | Cheaper abroad | Dearer at home |
Effects on the economy
A useful memory aid is SPICED: Strong Pound, Imports Cheaper, Exports Dearer. A stronger pound helps consumers who buy imports but can hurt exporters. A weaker pound helps exporters win sales abroad but makes imported goods, including fuel, more expensive, which can raise the cost of living.
Put these steps in order to show how a rise in interest rates can cause the pound to appreciate:
- The central bank raises interest rates
- Saving in pounds becomes more attractive to foreign investors
- Demand for pounds rises as investors buy the currency
- The pound appreciates (rises in value) against other currencies