2.2.3 - Currency markets and exchange-rate determination

Exchange-rate quotes and conversions

An exchange rate is the price of one currency expressed in another currency. Always identify which currency's value the quote measures.

Throughout this lesson the quote is US dollars per £1. A rate of 1.40 means £1 buys 1.40 US dollars. A rise to 1.55 means each pound buys more dollars, so the pound becomes stronger against the dollar. Quoting pounds per US dollar reverses the numerical direction; do not mix the two conventions.

To convert pounds into US dollars, multiply by the dollars-per-pound rate. To convert US dollars into pounds, divide by that rate:

At 1.40 US dollars per £1, £200 buys 280 US dollars. A purchase costing 700 US dollars requires £500. These illustrative conversions assume no bank fee or buying/selling spread. Such charges can change the amount a customer actually receives.

Trade and currency flows

Demand for a currency comes from people wishing to obtain it; supply comes from people offering it in exchange for other currencies.

Foreign buyers purchasing British goods or services may need pounds to pay the suppliers. More exports can therefore increase demand for pounds. For example, overseas visitors purchasing British hotel services create demand for the currency, directly or through their payment providers. At each exchange rate, more pounds are wanted, shifting currency demand right.

British buyers purchasing foreign goods or services need the seller's currency. To obtain US dollars, they may sell pounds, increasing the supply of pounds on the foreign-exchange market. More imports can shift pound supply right. The person buying foreign currency is simultaneously supplying their own; stating the market's currency avoids confusion.

Holding other influences constant, a higher dollar price of pounds makes British goods with unchanged pound prices dearer to foreign buyers, reducing demand for exports and consequently demand for pounds. It also makes foreign goods with unchanged dollar prices cheaper in pounds, encouraging imports and the supply of pounds. These responses help explain downward-sloping pound demand and upward-sloping pound supply.

Actual transactions may use invoicing arrangements, intermediaries and contracts. The diagram abstracts from those details to explain the direction of the underlying currency demand and supply.

Interest rates and speculation

Currency markets reflect financial decisions as well as trade in products.

An increase in British interest rates relative to overseas rates can attract savers or investors seeking higher returns on pound assets. Buying those assets requires pounds, raising pound demand. Some existing pound holders may also be less willing to sell them, reducing supply. Either change tends to raise the dollar price of pounds, other things equal. What matters is the relative return, together with perceived risk and expected currency changes; a rise in every country's rates need not favour the pound.