Currency Exchange Rate

Introduction:

There is a strong relationship between a currency exchange rate and the prevailing interest rate in that country, according to economic models a rise in the interest rate will lead to increased value of the currency over all the other currencies in the international market, on the other hand a decline in the interest rate will lead to a decline in value of the currency over all the other currencies. This paper focuses on this model and how it could cost a country billions of money.

We focus on the loss incurred by British government in September 1992. During this day the model mislead the decision of the UK government at the time and led to huge loses. The government raised interest rates to increase the demand for pound in the international market, this increase in demand was anticipated to make the pound stronger against other major currencies, however a speculative attack by investors led to the loss of funds, the government lost and some investors gained huge profits on that day.

Overview of the exchange rate interest rate model:

This model depict that there is a relationship between the prevailing interest rates and the exchange rate, using historical data a country can use the data to estimate an appropriate model that will help in forecasting future values. The model depicts that a rise in interest rate will lead to a rise in the value of the currency, when interest rates fall then the value of the currency declines, the following diagram shows the relationship between the two variables:

From the above diagram it is evident that an increase in the interest rates will lead to an increase in the value of the currency, however a decline in interest rates will lead to a decline in the value of the currency. However the assumption of this model is that there are no speculative attacks and that the exchange rate depends on the demand and supply of the currency.

Interest rates an exchange rate mechanism:

The relationship between the exchange rate and the interest rates can be demonstrated using two currencies from countries with different interest rates, we take hypothetical values and countries to demonstrate this and we choose country A and country B, for country a the interest rate is 4% and for country B the interest rate is 6%, those who have their funds deposited in country A will earn 4% for their investment, however it is more profitable to invest the funds or deposit the amount in country B due to high interest rates and therefore higher earning.

For this reason therefore investors will move their fund from country A to country B, investors from country A will exchange their money to get country B currencies, as a result of this the demand for country B currency will rise and therefore will the value of the currency. Therefore higher interest rates will encourage investors to invest in country B, if country B was to increase the interest rates from 5% to 10% then the higher will be the demand for their currency.

British forecast:

The exchange of the pound in 1992 was determined by the market demand and supply, in September the British government experienced a decline in the demand for their currency, many investors started selling the pound to acquire other currencies, as a result of this demand declined and therefore the pound lost value against other currencies.

The government had a role to play to resolve the crisis and this was done by increasing interests rates as described by the above model, the prevailing interest rates at the time was 10% and the government increased the interest rates to 12%, however despite this effort the investors still sold the pound to hold other currencies.

Realizing this problem the government on the same day announced an increase in interest rates to 15%, this was the second attempt to resolve the problem, however it was unfortunate that investors kept on selling the pound and purchasing other currencies, as a result of this the value of the pound declined and this resulted into a decline in the value of the pound against other major currencies, the diagram below shows historical exchange rate of the pound against the dollar:

The above chart shows the value of us dollar divided by pounds, when the pound appreciates in value then the value of our ratio declines, a decline in the value of pounds leads to an increase in the value of the ratio. Therefore from the chart it is evident that in the month of septembvet the british pound value aginist the dollar was low but after black Wednesday which is september 16 the pond started to appreciate and for this reason the us dollar / pound ratiodecline. This is to show that there was a declien in the value of the british pound and the attempytt to icnrease interest rates did not help the country to increase the demand for its currency in the market.

From our earlier discussion the increase in interest rate was to act as an incentive to encourage investors to move their funds into UK banks, the investors were expected to exchange other currencies into pounds and therefore increase the demand for the pounds, as a result of this the pound would gain value due to high demand, however this did not happen as anticipated, the governetmn however announced its withdrawal from the European exchange rate regime that evening after losing billions of pounds, it was estimated that the government lost over 3 billion pounds, however investors gained in the process and George Soros an investor is said to have made over 1 billion pounds profit that day.

From the above discussion it is evident that there is a strong relationship that exist between interest rates and exchange rates, however this model should not contain interest rate as the only independent variable but should also contain a variable that represent speculation from investors, the loss was due to speculative attack by investors where investors were well aware of the aims and objectives of the government to increase interest rates, the investors declined to purchase more pounds and they continued to sell the pound in the market.

For this reason therefore any estimated model requires that we take into consideration all the factors that may affect the dependent variable, the government assumed that by raising interest rates the pound would appreciate but unfortunately the investors were well aware of what the government was trying to achieve and instead of the pound appreciating the reverse occurred and the pound value declined and there was a major loss recorded.

Therefore there is need to take into consideration that models can be misleading and may lead to inappropriate decision, it is recommended that models estimated must include all the independent variables that have an impact on the independent variable, for example the interest rate exchange model should have taken into consideration the speculative independent variable that may have a positive or negative impact on the exchange rate.

Another solution is the use of the Mundel Fleming model that shows the relationship between the exchange rate and the output of the country, this model could be an alternative to estimate future exchange rates as a result of changes in the output of an economy. Therefore instead of using the interest rate exchange rate model a government may choose the Mundel Fleming model that may be more accurate and efficient in estimation.

 References:

 Bized (2008) historical exchange rate data, retrieved on 21st July, available at http://www.bized.co.uk/learn/economics/govpol/macropolicies/interest/exchange/interest_rate_3.htm

 Daniel G. and Neil T. (2002) European Monetary Integration, Longman publishers, UK

 Mundel A (2000) A theory of Optimum Currency Areas, McGraw Hill, New York

 Willem G and Paolo A (1996) Lessons from the 92 European exchange rate mechanism Crises, Cambridge University press, UK