Exchange rates The rate at which one currency can be converted into another currency is known as the exchange rate. It is the price of one currency expressed in terms of another countries currency, that is the external value of the currency.
Major cause of depriciation in a currency • A fall in domestic interest rates. • Higher inflation in the domestic economy than abroad. • A rise in domestic incomes relative to incomes abroad. • Relative investment prospects improving abroad. • Speculation that the exchange rate will fall.
Trade Weighted Index • This measures the value of sterling against a basket of currencies which are weighted according to their relative importance in UK trade. It takes into account how much it trades with other countries checks with whom the volume of trade is highest to see highest trading partner. All weights should add up to one. The most important trading partner is assigned the highest weight . The base year always starts at 100.
How to calculate the Trade weighted Index • UK trades with • US • 70% • Pound falls by 10% against $ • (10*o.7)=-7 • France • 30% • Pound falls by 20%against Ff • (20*0.3)=-6 • Base=100-7-6=87=TWI
Trade Weited Index Assume UK trades with France & US 70% of its trade is with US & 30% with France. The value of pound falls by 10% against $ & 20% against Ff. The TWI will change The fall in $ is 7% & fall in Ff is 6%. The average fall in the sum of these components is 100-13=87
Effective exchange rate • It takes into account how much trade the country does with the other countries & weights movements accordingly. It also considers the extent to which the country competes with other countries internationally.
Determination of exchange rate theories • The theory that in a floating system exchange rates adjust until a unit of currency can buy exactly the same amt of goods & services as a unit of another currency is known as purchasing power parity theory.
Portfolio balance theory • This theory suggests that exchange rates are influenced by interest rates. When interest rates are high, currency appreciation occurs as hot money flows in. When interest rates are low, currency depreciation occurs as hot money flows out.