Foreign exchangedemand, determines the rate. Relative supply and demand is caused, in turn, by the
extent to which individuals, businesses and institutions want to convert dollars into
sterling or sterling into dollars.
There are broadly five reasons why individuals, businesses or institutions may wish
to convert the home currency into a foreign one or vice versa:
l to enable them to exchange cash, received from a sale of goods or services in a for-
eign currency, to the home currency;
l to enable them to pay for goods or services in the relevant foreign currency (includ-
ing taking a holiday in the foreign country concerned);
l because they may feel that they would rather hold part of their wealth in the
foreign currency;
l to speculate, for example by buying a particular foreign currency in the expectation,
or hope, that its value will appreciate in relation to the home one;
l in the case of a central bank, to enable it to manage, or to try to manage, the
exchange rate between the two currencies.
The first and second of these are obvious enough. If these were the only reasons
for the existence of foreign exchange markets, exchange rates would tend to reflect the
relative exports and imports of goods and services between the two countries.
Individuals, businesses and institutions may prefer to hold part or all of their
wealth in the foreign currency rather than in the home currency. This might be be-
cause they have a belief that the foreign currency will strengthen relative to the home
one, so that they could convert back at a later date and have more of the home cur-
rency than they had originally.
They may alternatively prefer to convert to the foreign currency to enable them to
lend money to a borrower in the foreign country, who pays a higher rate of interest
than is obtainable in the home country. The relative strength of sterling in the late
1990s and early 2000s was ascribed to this factor. During that period, UK interest rates
were relatively high compared with those of many other economies. Governments,
through their central banks, ultimately determine interest rates. A government might
choose to have high interest rates to strengthen its currency in an attempt to manage
the exchange rate to achieve some objective, such as holding exchange rates relatively
fixed (‘pegged’) against certain other currencies. This was not the case in the UK at this
time, however. The high UK rate of interest was the Bank of England’s weapon in
an attempt to curb inflationary tendencies in the UK economy. Most countries tend to
use interest rates as the main tool of counter-inflationary policy.
The fourth reason, speculation, tends to be regarded as a parasitic and maligned
activity. Speculators would argue that their activities tend to lead to more effective
and rational markets, however.
The fifth reason why there might be a wish to convert the home currency into a for-
eign one is also concerned with managing the exchange rate. Governments, usually
through their central banks, create supply and demand for their national currencies
by selling them or buying them. Thus the UK government may convert some of its
reserves of dollars into sterling (that is, sell dollars, buy sterling) in an attempt to
strengthen sterling against the dollar. Alternatively, it may do exactly the opposite in
an attempt to weaken sterling.
Both the adjustment of interest rates and intervention in the market are much-used
practices of governments as they attempt to manage their exchange rates.