This is the standard price/quantity situation, except the 'price' is the price of the pound in terms of the dollar (i.e. the exchange rate of the pound against the dollar) and the 'quantity' is the quantity of pounds being demanded. If the price of the pound in terms of dollars drops in value from $2 to $1, British exports in the USA will become much cheaper relative to the home-produced goods on offer. The demand for these British exports will rise in America, and the demand for pounds to buy these exports will also rise as a result. So at lower prices (or exchange rates) more pounds will be demanded, and vice versa. Why is the supply curve upward sloping?
In the diagram above, the price of the pound in terms of dollars has risen from $1.50 to $2. This will make the price of imports from the USA fall and, assuming the price elasticity of demand for these American imports is greater than one, the amount of pounds that UK consumers will need to supply in order to buy the dollars to buy the goods will rise. So at higher prices (or exchange rates) more pounds will be supplied, and vice versa. Putting demand and supply together In the example, below, we shall be looking at what happens to the exchange rate when an American decides to buy a British made Rover car. There are two diagrams. One shows what happens to the price of the pound in terms of dollars, and the other shows what happens to the dollar in terms of the pound:
If an American buys a British Rover, there will be an increase in the demand curve for pounds. The demand curve will shift from D1 to D2. In order to buy these pounds the supply of dollars will have to rise. The supply curve in the second diagram shifts to the right from S1 to S2. In the first diagram, the 'price' of the pound rises from £1 = $1.50 to £1 = $1.60. In the second diagram, the 'price' of the dollar falls from $1 = £0.67 to $1 = £0.63. Obviously, if the price of the pound in terms of dollars rises, the price of the dollar in terms of pounds must fall. Note that the prices used above were made up. It is very unlikely that the changes in demand and supply of pounds and dollars will cause the exchange rate to change by so much! From this analysis, it follows that if the value of exports into the USA (from the UK) exceed the value of imports into the UK (from the USA) then the value of the pound in terms of dollars will rise and the value of the dollar in terms of pounds will fall. If the UK imports more than it exports (which is more usual) then the value of the pound will fall.
What affects the 'price' of the pound? The supply and demand analysis above worked quite well in the days before the war and, to a certain extent, in the three decades afterwards. This was because there were tight capital controls, so most of the demand for foreign currencies was for the purposes of importing goods and services. Trade deficits would lead, eventually, to a fall in the exchange rate, and trade surpluses would cause the exchange rate to rise. In the last twenty years, capital markets have been opened up; there are now very few controls on the flow of capital worldwide. In the UK, the controls on currencies were abolished in 1979; one of the first acts of the new Conservative government. This has created many more reasons to demand and supply currencies. Foreign direct investment The UK is the recipient of the second largest amount of capital from abroad for the purpose of direct investment. Foreign direct…