Between 1995 and 1997 the effective exchange rate of the pound sterling

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Between 1995 and 1997 the effective exchange rate of the pound sterling

appreciated by 20%. What factors might explain this increase in the value

of the pound?

5. Between 1995 and 1997 the effective exchange rate of the pound

sterling appreciated by 20%.

(a) What factors might explain this increase in the value of the

pound?

There are several reasons that contribute to the appreciation of the

pound.

INTEREST RATES

Interest rates have a large effect in a world where financial capital

can move freely between countries.

If for example the UK interest rates are high relative to elsewhere

this attracts inflows of money into the UK seeking to take advantage

of the high interest rates. This "interest differential" boosts the

demand for the currency and can cause its value to rise.

ECONOMIC GROWTH

Countries experiencing a rapid economic growth often find that their

exchange rate is strengthening. Traders in the currency markets may

take the rapid growth to be a sign of general economic growth and

"mark up" the value of the currency as a result.

Also economies with strong "export-led" growth may see their

currency's rise in value. Japan is a good example of this in recent

years. The Euro was weak during the first six months of its existence

in part because the financial markets were worried about the slow

growth of the European economy and the persistently high level of

unemployment.

INFLATION

As with the UK, as there are low levels of inflation, this has meant

that our goods have become cheaper and demand for our exports has

increased. Foreigners have bought pounds to finance our goods. This

has meant that the value of the pound has increased. However this is

like a cobweb with many downsides such as a rise in inflation as

exports are a component of aggregate demand.

In the long run, those countries with higher than average inflation

see their exchange rate fall. When inflation is high, a country

becomes less competitive in international markets causing a fall in

exports (a demand for a currency) and a rise in imports (a supply of

currency overseas). A fall in the exchange rate may be needed to

restore a country's competitiveness in overseas markets.

THE BALANCE OF PAYMENTS

When we operate at a current account surplus i.e. when our

exports>Imports, then foreigners will need pounds in order to finance

the exports we sell them. They will buy pounds. This will result in

the value of the pound to increase.

Selling exports represents a demand for the domestic currency from

foreign importers. When US consumers buy British Whisky they supply

dollars and this is eventually translated into a demand for pounds.

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