Today, most major economies operate using a flexible exchange rate system whilst a few operate on a fixed exchange rate system. These two systems are discussed in a bit more detail in the following lines. Fixed and floating exchange rate regimes A fixed exchange rate regime is, “System in which the value of a country's currency, in relation to the value of other currencies, is maintained at a fixed conversion rate through government intervention. ” Government intervention in this case can come in the form of mostly monetary instruments or policies. The graph below demonstrates a fixed exchange rate system:
In a fixed exchange rate system, the government deliberately tries to influence the exchange rate. A higher amount of pounds in circulation for example means that the value of the pound will be lower against other currencies and vice versa. By tempering with interest rates, or issuing treasury bills and other monetary instruments etc, the government can influence the amount of pounds in circulation and hence the exchange rate. In the United Kingdom a floating exchange rate system is used. In a floating exchange rate system, the exchange rate is determined by market forces.
This is reiterated by an investment promotion website which defines it as , “Currency exchange rate which is determined by free market forces, rather than being fixed by a government. The market forces here is mainly in reference to a country’s exports and imports. Its balance of trade account as well as other factors. The graph below gives a brief description of how a floating exchange rate system works. All things being equal, a floating rate exchange rate system creates equilibrium for the demand and supply of pounds in the exchange market.
When the demand for pounds reduces shown by Q1 to Q2 maybe as a result of bad economic data coming from the UK that makes investors shun the British pound, the supply of pounds also decreases, as seen by a shift in the supply curve to the left. Factors that influence the exchange rate in the U: 1. Inflation If inflation in the UK is lower as compared to that in its major trading partners, this translates to cheaper exports from the United Kingdom. British products will be cheaper as compared to others, demand for them will increase and hence the value of the pound.
On the other hand foreign good will be more expensive hence British citizens will spend less on imports thus supplying less pounds to the currence markkert. This translate to a stronger pound. 2. Interest Rates If the Governor of the Bank England decides to reduce interest rates, this will make the United Kingdom a less lucrative destination to invest in. Thus investors will pull their funds away from the British money markets. In doing so they increase the amount of pounds in the market, forcing the pound to depreciate. 3. Speculation In modern times this has become a very important factor.
Trading in currencis has become a lucrative way of making money, as a result of the internet. The situation created is that there are just lots of people who are holding on to a lot of pounds for none other reason than just mere speculation. If speculator beleive that the pound is going to appreciate in future, they will buy lots of pounds from the foreign exchange market and this does have a tremendous effect on the market. 4. Competitiveness of British goods abroad If British goods are of higher quality and they are in great demand abroad, demand for pounds will increase and thus causing the pound to appreciate in value.
5. Strength of other currencies when compared to the pund Strength of other currencies compared to pounds does play an important role. If investors perceive the pound as a stong currency, demand for it will be higher in the foreign exchange market and hence its value as well. 6. Balance of Payments The effects of a balance of payment can summarized as stated in the excerpt from a busines source, “A large deficit on the current account means that the value of imports is greater than the value of exports. If this is financed by a suplus on the financial/ capital account then this is OK.
But a country who struggles to attract enough capital inflows will see a depreciation in the currency. (For example current account deficit in US of 7% of GDP is one reason for depreciation of dollar in 2006)” 7. Public/government debt Budget defeceits are usually financed through issuing of bonds to the public. In monetary theory, when a government spends beyond its means this creates some form of inflation and this will of course affect the value of the local currency How flactuations in the exchange rate will affect the activities of Estee Lauder a British company
The diagram below shows currency flactuation between the Pound and the Euroe in recent times: (image adapted from: http://i. thisislondon. co. uk/i/pix/2009/01/PoundEuroES_415x375. jpg) A stronger pound simply means that prices of imported goods are cheaper. This means that the price of imported raw materials to make Estee Lauder’s beauty products is lower. Thus cost of production will be very low. On the other hand however if Estee Lauder decides to export some of its products to Germany for example, the amount of sales will be low, because British goods will be more expensive for people using Euros.
This situation can be reversed if we are talking of a weaker pound as compared to the euro. However a strong pound helps keep a check on inflation ensuring economic stability and making sure the company finds strategies to remain competitive. Thus the study of the exchange rate markets is of mass importance and its influence on a company’s operations cannot be underestimated. Works Cited "Factors influencing exchange rate - Economics Help. " Economics Help - Helping to Simplify Economics. 4 May 2009 ;http://www. economicshelp.
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html;. "Tutor2u - economics effects of exchange rate changes. " Rapid revision, teaching and e-learning resources for Business Education ; the Humanities. 4 May 2009 ;http://tutor2u. net/economics/content/topics/exchangerates/econ_effects. htm;. Lowery, Adrian . " What factors influence exchange rates and make a currency strong or weak? | This is Money . " Financial Advice, News, Help ; Guides from This is Money UK . 4 May 2009 ;http://www. thisismoney. co. uk/investing-and-markets/article. html? in_article_id=429456;in_page_