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The exchange rate is the price of one currency expressed in terms of another currency. For example, £1.00 = €1.13 or £1 = US $1.20. The value of a currency is determined by supply and demand.

Why exchange rates are important

Changes in exchange rates can affect the transportation and sale of goods or services imported into a country, as well the price of as goods exported abroad from the UK. Increasing globalisation and improved technology have increased the number of businesses that buy and sell overseas, and all of these businesses are affected by changes in exchange rates. These businesses will need to consider exchange rates when agreeing prices, otherwise a good deal could quickly turn into a bad one if the exchange rate changes. Large and unexpected changes in exchange rates can create uncertainty for businesses that trade overseas.

The impact of exchange rates

If the value of the pound increases, more foreign currency can be purchased for the same number of pounds. For example, if the value of the pound changes from £1 = US $1.20 to £1 = US $1.25 then £100 would now convert to US $125 instead of US $120. This is known as an appreciation in the value of the pound.

A depreciation in the value of the pound, eg from £1.00 = US $1.20 to £1.00 = US $1.10, would mean that less foreign currency can be obtained for the same amount of domestic currency. So, the pound has become weaker.

Changes in exchange rates can have a significant impact on the economy. A UK business that exports products will benefit from a fall in the value of the pound. Overseas firms will receive more UK pounds for their money, so they will pay less for the UK’s products. However, UK firms that import raw materials will have to spend more pounds to obtain the same foreign currency, so they will pay more for those raw materials.