Exchange rate
Section A Prices of goods and services and exchange rates
Since the concept of division of labor and comparative and absolute advantage was brought forward and economists and governments started to appreciate the advantages they will get with the application of these systems. Countries since then have developed a tendency to produce those goods, only, in which they have a comparative advantage in order to utilize its scarce resources in the best possible manner and obtain the maximum possible outcome from them. These concepts were developed to enable nations to take full advantage of international trade. Moreover, faster means of communication and transport meant that goods around the nations can take full benefits of the goods that they were best at producing and the goods in a country could be matched against their counter parts in another country. This matching of prices of goods and services meant that consumers demand the goods and services that presented them with maximum utility at the most economical price. Exchange rates provided a direct link between them as any changes in exchange rates would result in changes in their prices as well. This impact became more visible in the recent years when the oil prices were most uncertain and crossed their hundred dollar threshold and disturbed the exchange rates systems around the globe. It specifically brought about changes in the dollar exchange rates forcing it to reach unpredictable levels which in turn forced the prices of goods and services to fluctuate.
There are rarely any products and services that are fully produced with in a geographical boundary. One or other component is bound to be brought from other country. These exchange rate adjustments were more important in this context, as the costs of commodities and the cost of provision of services were greatly altered because of this and manufacturers were left with no option but to change the prices of these commodities. As most of the products have oil as their primary input the need to bring a change in the prices of the goods was yet, more evident because firstly the oil was getting expensive and secondly, all countries required foreign currency to pay their bills. This impact was not only for producers who manufactured goods locally and had a market for their goods somewhere else in the world but also those who sold their products domestically. Not only the manufacturers but also importers were forced to sell their goods at an altered price due to the impact that the exchange rates had on the goods they imported. Many people are of view that the changes in the currency exchange rates can easily predict the future prices of commodities and services and this holds truth to a large extent. While many are convinced that these are the reasons behind the link of the prices of goods and services but do not also negate the concept that many other factors play a part in the determination of prices. Due to this a casual relationship between the prices of goods and services and exchange rates can not be established. Although a major hurdle in all of this is the unpredictability not only of the future but also the exchange rates which has witnessed unusually inconsistent movements in the recent past.
Section B Factors that cause changes in exchange rates
The exchange rates between two countries are primarily determined by supply and demand in the foreign exchange markets. Demand generates from individuals, firms and governments who want to buy the currency while anyone willing and able to sell currency generates supply. Before we can analyze the factors that cause these changes it will be helpful to have a look at the recent trends in the currency markets. The following table is an average annual currency exchange rate for the British Pound as recorded by Forecast chart, 2010.
Pound sterling is analyzed against US dollar since is used as a yardstick to value many commodities and is generally accepted, also because both are amongst the most trade currencies around the world other than being world economic leaders. The changes observed during the period were a combination of strengthening dollar and weakening Pound sterling. Perhaps the major factor that led to changes in foreign exchange rates during the period were the economic conditions through out the world.
After following a trend of slight rises and falls during late nineties in 2001 rose before falling again but it does not seem that the real reason for the fall after 2001 were 911 incident although some observers feared that might be the case. During 2006 economy has started slowing down but it was not until 2008 that United Kingdom together with the rest of the world came to realize the gravity of the situation.
Early 2007 the Pound sterling stood at 1.96 level after as series of rise and falls during 2006. During whole of 2006 Pound sterling strengthened reaching its highest ever mark of 2.11 in November but this could not be sustained because of the economic situation and it dropped back to 2 in a very short time and 2008 was not very good for pound sterling. 2009 saw the worst of economic crisis and Pound sterling dropped still more forcing dollar down to all time low 11.41 in January 2009. But since then as can be observed dollar has gained. Having seen the trend we can now consider the factors that have lead to such a trend. Portfolio of investments
There were times when investors thought it safe to invest with in geographical boundaries but now investments whether they are in stocks, bonds or in financial institutions are done keeping in mind the profits that it will earn. Investors do not hesitate to invest in concerns abroad as long as it gives them higher profits. With Investors venturing investments around the globe the exchange rates are bound to be affected by them. Exchange rate changes clearly reflect this.
Foreign investment
United Kingdom historically received a significant amount of total investment of the world it was not different during early 21st century and it has also been investing in other countries, this has helped to shape the exchange rates as it creates supply and demand for currency.
During early 21st century funds were flowing in Britain helping it economy but situation turned and investment in Britain went down drastically as compared to any other country partly due to the fact that economy through out 2009 did not show any appreciable signs of improvement. The economic situation did not help to convince already reluctant investors to invest in Britain and according to a report by UN Conference on Trade and Development (Unctad) investment in Britain has decreased drastically. Investment into Britain fell by half to 97bn, while outflows, or British companies making investments abroad, collapsed to 111bn from 275bn the previous year. A cause of this is seen to be the state of affairs in United States since it is a major investor in United Kingdom concerns and a reason why the blow was harder for Britain. The impact was doubled due to the reluctance from investors with in Britain to invest abroad, and create a supply, since the Pound sterling was falling, as observed earlier. The remittance of profit of United States based Multi National Corporations also aggravated matters. Britains stock of foreign-owned investment projects fell over to 983bn in 2008 from a record 1.35tn in 2007. Most other countries saw far smaller falls. The UK drop was also much larger than the drop in global foreign investment to 1.7tn which was estimated to be 2tn in 2007. This was not anticipated since UN Conference on Trade and Development (Unctad) predicted a lesser fall (Guardian, 2009).
Interest rates
As discussed above investors tend to pursue investment options that give them the best returns so for instance if interest rates are high in United Kingdom the investors will, in an attempt to earn higher returns, invest in financial institutions of Britain. If a significant number of investors reacted in such a way the increased supply will force a change in exchange rates and in the long run, if floating exchange rates are in operation, the forces acting on their own will bring currency rates to a level that will make it impossible for the investors to take advantage of the increased profits.
This is what exactly happened in 2007 when an expectation of rise in interest rates together with problematic Housing Market in United States forced Pound sterling to its highest level of 2.11 in more than 26 years (Guardian, 2007). This move was with expectation that interest rates in United Kingdom might increase to 6 percent while in United States it was expected that a problem in housing sector will compel government to drive the interest rates below 5.25 percent. During this time United Kingdom had highest interest rates in group of seven leading economies so investors not only from US but also from rest of the world were eager to invest in UK. The news that the economy might improve even failed to halt the decline of dollar. Thereafter as the recession hit its full force the government had no option but to reduce the interest rates one of the factors that were responsible for bringing down Pound sterling from all time high to 1.41 with in a span of just two years. The exchange rate changes were not with out the fact that the demand and supply forces were acting as mentioned earlier. Investors were de motivated and investment, as observed, was low. The speculations suggest that given the current state of economy the government will again lower the interest rates if this is the case it might not help Pound sterling.
Current account
In 2002 UK current account deficit was 18,965 billion pounds and the situation did not improve in the later years resulting in pressure on pound to fall (bized, 2003).In 2009 UK had the third highest current account deficit in the world (Economy watch, c2009). A couple of years of economic growth together with an increase in consumer spending during the recent past with an inclination towards foreign goods and interest rates changes, compiled to the current state of current account deficit and resulted in an impact on exchange rates.
Inflation
It is held, theoretically though, that exchange rates will try to bring the purchasing power of two countries in equilibrium. So they will continue to fluctuate under floating exchange rates until there is parity between the purchasing power of the two countries. If we believe this theory to be true than any inflation in a country will trigger the exchange rates to change in an attempt to bring purchasing power in equilibrium again. In other words, foreign currency depends upon the comparative purchasing power of each currency and that exchange rates will vary over time to relative price variations.
This is again is true for the prices of goods. A manufacturer facing inflation in his country will increase the prices of goods of his products in order to maintain his profit margin. Alternatively, if because of inflation in another country the price of raw materials changes the producer will in this situation also, will be forced to change the price of his goods or the price at which he provides services. This in turn will again start the cycle of exchange rate fluctuations.
As the exchange rate was weakened in early 2000s there was some inflationary consequences witnessed due to them but they were not disturbing.
PIMCO (2007) observes that although there was news of increasing inflation in the economy during 2007 the Pound sterling still did not react and continued to strengthen. The interest rates were recorded during 2007 to be 3.1 over year in March versus the 2.8 consensus. During this entire time Pound sterling was appreciating. This was surprising as most economic texts would predict increasing inflation to be followed by depreciating currency, so would the theory explained above. Though this was only short lived as in the long run when inflation continued to increase all of the theories were held to be true as Pound sterling dipped dramatically to an extent that was beyond imagination of many. Thus it can be safely concluded that though due to some reasons the exchange behaved unusually once the fervor was over they did show their impact on foreign exchange rates.
Government reserves
Role of government reserves are more evident in fixed exchange system were government inject or extract funds in order to keep currency at a certain level. However it would not be fair to conclude that there is no role of reserves and there is no government intervention in floating exchange rate, as it is there although rare. Government only intervenes when it feels that currency price has dramatically fallen or risen. UK government did intervene during late 1990s to stabilize the currency and if Pound sterling continues the way it is going now government intervention might be necessary. Although government has tried other macro economic measures in an attempt to stabilize the currency direct intervention has not been used.
Speculation
Speculations have always had a hand in driving the exchange rates, the extent to t asserts its power and makes its presence felt is always debatable. With all the bulk of foreign exchange transactions taking place, all cannot be trade related there is always some degree of speculation going on under covers. Their effects, therefore, cannot be negated during the above mentioned period. Though these speculations base themselves on all above mentioned factors still there is an element of wild speculation rather than rational calculated speculations. Some people are of view that future speculation does not affect current prices. Though it will be futile to deny that future speculation does trigger demand in the market resulting in changes in the prices if it is a strong enough speculation to move significant number of buyers or sellers.
Conclusion
Although economists have tried to take account of all the factors that can influence the exchange rates and trigger their movement their will always be some factors that will be ignored. The assumptions around the models and theories with the help of which they try to understand the likely cause, have also got flaws in them and in the opinion of many observers they do not belong to the real world. This leaves another space that some causes will always remain unidentified. However, these do regulate exchange rates of the world and have proved quiet useful in the current economic situation. Yet finding the causes will only be of limited use in giving a solution out of the current economic crisis. It is time we look for quick solution before the world economy dips any further or we witness yet another bizarre movement in exchange rates.