A Simple Explanation Of Exchange Rates

Exchange rates refer to the price (or value) of one country`s currency against that of another country s or economic blocs (for example the EU), currency. At the time of writing, £1 (UK) is currently worth around $1.26 (US). This means is you exchanged £100, you would get $126 back in return. From the American s perspective $1 (US) is currently worth £0.79 (UK). This means that if they were to exchange $100, they would get £79.

The value of currencies fluctuates (changes) over time (even during one day). These fluctuations depend on: the economic strength/performance of countries market speculation (betting) on the future value of these currencies what the interest rates (the cost of borrowing money, or the reward for saving money) are the amount of goods and services exported (goods/services sold to other countries) or imported (goods/services bought from other countries) and the amount of investment money flowing into countries, and an issue which is becoming importantly recently, is a country s ability to pay its government debt.

Essentially, fluctuation means that the price of one currency against another may change over time. Now, if the currency appreciates (rises in value), for example £1:$1.80, this means £1 (UK) will now be worth more ($1.80 (US)). This will mean that the price of goods and services from America falls, so everything from the US appears cheaper than before so UK customers will import more from the US. This is good for British people going to America on holiday, as they can buy more $s for their £s, or if they are buying American goods as they are cheaper now, so we will tend to buy more goods from America. However, it also means that the UK Pound is more expensive for Americans. They will find UK goods cost more, as before they could buy £0.88 for $1 when the exchange rate was £1:$1.38, now $1 buys them £0.55, so British goods will appear to increase in price, thus UK goods cost US customers more. This means that UK businesses will find it harder to sell as much to the US, meaning our exports fall. With imports rising and exports falling, this can lead to a worsening of the UK`s balance of trade (exports (X) - imports (M)). Now, this means more money leaves the UK economy and more arrives in the US economy. Now, if you flip and reverse all of that, and you can work out what happens if the Pound depreciates in value i.e exports rise as UK companies can sell more abroad as our goods appear cheaper. Similarly, imports fall, which means more money flows into the UK economy. The thing is, the more a country exports, the higher the demand for that country s currency, which itself could lead to the currency appreciating (increasing) in value.

Fluctuations can be small, but in some cases the trend can move in one direction for some time. In the not-so-distant past, you could buy $2 for £1, and in the past the rate was close to £1:$1.50. As you can imagine, this has quite a dramatic effect on how much businesses and consumers can buy or sell goods and services. However, while there can be an effect on demand, if the goods are habitually used or a necessity, the additional cost may have to be absorbed, for example for food and energy. As many businesses often agree price in advance, an unexpected currency fluctuation can affect the value of the money you receive.
OK, imagine you agree a price 12 months in advance of $1000 (£500) when £1:$2. If the currency fluctuates to £1:$1.50, you stand to really gain if you were exporting goods, because your $1000 payment had been expected to earn you £500 but actually you received £666.67. This is however, worse if you were importing goods, as you are now paying £166.67 more than you expected.

Currency (money) and commodity (raw materials) traders essentially make these bets all the time. Predicting and speculating on the price of money and materials in the future. If they expect the value to rise over time, they might buy lots up front now while the price is low, or set up an option to buy things in the future.

If their prediction is correct, they have done well. However, if they have bet against the market and the value of the currency or commodity they are buying falls over time, buying at today`s price was a costly mistake.

Remember, the key point is that exchange rates measure the value on currency against another, this will then affect the price we pay for imports and the money received for exports. From there you can look at the effects this could have on consumers, business and the economy.