Thursday, May 17, 2007

What Causes an Appreciation in the Exchange Rate?

An appreciation means the exchange rate (£) becomes stronger (worth more) against a basket of currencies.

Pound Sterling will become stronger if there is higher demand for Sterling, or lower supply of Sterling.

Reasons for an appreciation in the Exchange Rate

1. Increase in Interest Rates.

Higher interest rates make it more attractive to save in the UK (there is a better rate of return on saving accounts). Therefore, there will be an inflow of hot money (people holding currency in UK saving accounts). This increase in demand for sterling causes the appreciation.

2. Lower Inflation.

If the UK has relatively lower inflation than other countries, this makes UK goods more competitive against foreign goods. Therefore, there will be more demand for British goods and hence sterling. This is a long term factor which will cause an appreciation in the value of the exchange rate.

3. Increased Competitiveness of UK goods.

Increased productivity and greater competitiveness will make British goods more attractive.

4. Expectations

Speculation plays an increasing role in the determination of exchange rates. If investors feel a currency is likely to appreciate in the future they will buy now and actually make it occur. E.g. if people expect interest rates to rise the currency will rise.

5. Surplus on Current Account.

This causes an inflow of foreign exchange into the economy. Typically, a large current account surplus will cause an appreciation in the exchange rate (unless there is a similarly large outflow on financial and capital account)

6. Higher Economic Growth.

Stronger economic growth tends to cause an appreciation in the exchange rate. This is because with higher economic growth, the country is likely to see an increase in interest rates. Also higher economic growth tends to cause greater confidence in the economy. However, it depends on the type of economic growth. If the growth is led by higher consumer spending, this will cause a rise in imports which could lower the exchange rate. If growth is export led, the currency should rise.

7. Buying Domestic Currency

If China sold its US dollar assets and bought Chinese assets, there would be an appreciation in the value of the Yuan


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