Why the dollar/pound exchange rate matters

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Just some quick notes about what has been happening with the currency and what that directly has to do with us.  Let’s simply things down for explanation.

Supposing the £1 is trading at $2. It obviously affects when you go on holiday because you want to get as many dollars when you go so you can spend them and then you want the dollar rate to reduce coming home so you get as many pounds back as possible.  Time your visit right and steward your money wisely and you might come home with not far off what you left with. Get it wrong and you lose money without even spending any of it.

However, it’s not just about holidays.  If an American company manufactures goods that cost $10 to make and sell at $50. This means that after exchange to UK pounds he is selling at £25 here and making £20 margin which translates to $40.

However, should the exchange rate change and the £1 slips to $1.50, this means that the goods still cost $10 to make but when he sells them here in the UK, he has a choice. He either sells them at the equivalent of $50 which is around about £34.  This means that the cost has gone up in the UK by about 36% and so is contributing to inflation. Alternatively, he can choose to sell at £25 still to hold onto the British market but then he only gets $37.50 dollars back meaning that his margin has gone down from $40 to $27.50.  Imports therefore either become more expensive, pushing up inflation or less profitable making vendors less willing to trade in the UK. 

On the other hand, consider a UK manufacturer selling to the States. If manufacturing costs £10 and they sell at £50, it costs $100 to buy the product in America and the manufacturer makes £40 margin.  However, when the pound drops to $1.50, the $100 dollar he sells at is worth £66.67 when exchanged back. He can either increase his margin to £56.67 or he can reduce the price to £75 and so make the same amount of profit but because his goods are more competitive, he is able to sell more.

A weak pound therefore is bad for inflation and not great for imports. At the same time, it’s good for exports which may well lead to economic growth which also means more jobs and more tax revenue for the Government.

However, there is another factor. The price of currency is determined by whether or not the money markets want to buy and hold your currency as reserves. The decision is based on whether they can make a profit through saving, investing and trading in pounds. This will reflect their perception of the stability of a currency.  So, aside from the negative factors in terms of inflation, there is a further problem that if the pound is falling or is bouncing around a lot then it suggests that the financial markets have lost confidence in your economic policy. This is likely to discourage them from investing in the country. And if they are less willing to invest in the country then that makes it harder for the Government to borrow as well meaning that the cost of borrowing goes up.  This increases the Government’s deficit but also means that our own interest rates have to go up (which they are also doing because of the inflationary pressure of the low pound.

There is therefore a balance to be kept. Governments may also be willing to see a currency devaluation during economic hardship but they want their currency to be stable and not to low to indicate confidence in the economy and encourage investment.

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