An exchange rate is literally the price for which the currency of a country can be exchanged for another country's currency. Factors that influence exchange rates include interest rates, inflation rate, trade balance and of course speculators.
As a general rule, high inflation will lead to depreciation in the value of a domestic currency, and a vica-versa. If the inflation in the UK for example is relatively high in comparison to other countries, the value of the pound will tend to reduce. High inflation in the UK means that UK goods increase in price quicker than say European goods. Therefore UK goods become less competitive. Demand for UK exports fall and we see a fall in demand for Pound Sterling, thus a fall in the currencies value. This is illustrated in the diagram by a leftward in shift in UK exports to the EU (D1-D2), caused by the relatively high inflation. The resulting position of the demand curve sees a drop in the GBP value from P1 to P2. Also, UK consumers will find it more attractive to buy European imports. Therefore they will supply pounds to be able to buy Euros and the Euro imports. This increase in the supply of pounds decreases value of Pound Sterling.
The interest rate influences the exchange rate because it influences the demand and supply of currencies on the foreign exchange markets. For example, if the rate of interest in the US was 3% but was 5% in the UK, there may be advantages gained from transferring funds in dollar based securities to those denominated in Sterling. Much like moving money from a bank account paying 3% to another bank account paying a higher rate of interest. If this happened, there would be a move towards selling dollars on the foreign exchanges and buying Sterling, with the result that the demand for Sterling would rise and the supply of dollars would also rise. This would put pressure on the price of Sterling and push its value up against the dollar. The diagram illustrates the effect on the US Dollar of a fall in its domestic interest rate. Supply of the Dollar increases, resulting in a rightward shift of the supply curve from S1 to S2. This leads to a drop in the value of the Dollar against the pound from P1 to P2.
Speculators also play a significant role in controlling the exchange rate. If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation.
Explain how a central bank may intervene to stabilise the exchange rate
A central bank, reserve bank, or monetary authority is an institution that manages a state's currency, money supply, and interest rates. They withhold the ability to manipulate its nations exchange rate in order to stabilise it. This is particularly true in a floating system. A floating regime is one where currencies are allowed to move freely up and down according to changes in demand and supply. Under a floating system a currency can rise or fall due to changes in demand or supply of currencies on the foreign exchange market.
Central banks, such as the Bank of England, have the ability to manipulate exchange rates by buying or selling currencies on the foreign exchange market. To raise the value of the pound, the bank of England buys pounds, and to lower the value, it sells pounds. The Bank of England influences exchange rates through its Exchange Equalisation Account (EEA). This account, which holds the UK’s gold a foreign currency reserves, was established with the specific aim to stabilise the value of the pound. In the diagram this intervention by the Central Bank is…