Between 1995 and 1997 the effective exchange rate of the pound sterling :: Economics

Between 1995 and 1997 the effective exchange rate of the pound sterling appreciated by 20%. What factors might explain this increase in the value of the pound? 5. Between 1995 and 1997 the effective exchange rate of the pound sterling appreciated by 20%. (a) What factors might explain this increase in the value of the pound? There are several reasons that contribute to the appreciation of the pound. INTEREST RATES Interest rates have a large effect in a world where financial capital can move freely between countries. If for example the UK interest rates are high relative to elsewhere this attracts inflows of money into the UK seeking to take advantage of the high interest rates. This "interest differential" boosts the demand for the currency and can cause its value to rise. ECONOMIC GROWTH Countries experiencing a rapid economic growth often find that their exchange rate is strengthening. Traders in the currency markets may take the rapid growth to be a sign of general economic growth and "mark up" the value of the currency as a result. Also economies with strong "export-led" growth may see their currency's rise in value. Japan is a good example of this in recent years. The Euro was weak during the first six months of its existence in part because the financial markets were worried about the slow growth of the European economy and the persistently high level of unemployment. INFLATION As with the UK, as there are low levels of inflation, this has meant that our goods have become cheaper and demand for our exports has increased. Foreigners have bought pounds to finance our goods. This has meant that the value of the pound has increased. However this is like a cobweb with many downsides such as a rise in inflation as exports are a component of aggregate demand. In the long run, those countries with higher than average inflation see their exchange rate fall. When inflation is high, a country becomes less competitive in international markets causing a fall in exports (a demand for a currency) and a rise in imports (a supply of currency overseas). A fall in the exchange rate may be needed to restore a country's competitiveness in overseas markets. THE BALANCE OF PAYMENTS When we operate at a current account surplus i.e. when our exports>Imports, then foreigners will need pounds in order to finance the exports we sell them. They will buy pounds. This will result in the value of the pound to increase. Selling exports represents a demand for the domestic currency from foreign importers. When US consumers buy British Whisky they supply dollars and this is eventually translated into a demand for pounds.