Exchange rates (AQA GCSE Business): Revision Notes
Exchange rates
What are exchange rates?
When businesses trade with customers and suppliers in different countries, they need to consider the value of each country's currency. The exchange rate shows how much one currency is worth compared to another currency. Changes in exchange rates directly affect the costs and profits of international business transactions.
Understanding exchange rates is essential for any business involved in international trade, as even small changes can significantly impact profitability and competitiveness.
Understanding imports and exports
Imports refer to goods and services that businesses buy from other countries. These could be raw materials needed for production, finished products for resale, or services that companies purchase from overseas suppliers.
Exports are goods and services that businesses sell to customers and companies in other countries. When a UK business sells its products abroad, these sales count as exports.
The balance between imports and exports (known as the balance of trade) is a key economic indicator that reflects a country's economic health and international competitiveness.
When a currency becomes stronger (appreciation)
When a currency appreciates, it becomes more valuable compared to other currencies. This means that people need to pay more of their own currency to buy pounds sterling, while UK businesses need less pounds to buy foreign currencies.
Effects of currency appreciation:
Impact on businesses that export:
- Their products become more expensive for foreign customers
- This typically leads to fewer sales overseas
- Export businesses generally struggle when their currency strengthens
Impact on consumers:
- Imported goods become cheaper to buy
- People can afford more variety and better value from international products
- This is generally positive for household budgets
Impact on businesses that import raw materials:
- Raw materials from abroad cost less in pound terms
- This reduces production costs significantly
- Lower costs allow businesses to either increase profits or reduce prices to compete better
- This flexibility is particularly valuable in competitive markets
Impact on local businesses:
- They face increased competition from cheaper imported goods
- May struggle to compete on price with foreign alternatives
Worked Example: Currency Appreciation Impact
Consider a UK company that exports furniture to Germany:
- Before appreciation: £100 furniture costs €120 for German customers
- After 10% appreciation: £100 furniture now costs €132 for German customers
- Result: German customers find the furniture more expensive, leading to reduced sales
Meanwhile, a UK manufacturer importing wood from Canada:
- Before appreciation: $100 wood costs £80
- After 10% appreciation: $100 wood now costs £72
- Result: Lower production costs, improved profit margins
Key Point: Currency appreciation creates a "double effect" - it helps businesses that import but hurts those that export. This is why some businesses benefit while others struggle from the same exchange rate movement.
When a currency becomes weaker (depreciation)
When a currency depreciates, it becomes less valuable compared to other currencies. This means it becomes cheaper for other countries to buy the weakened currency.
Effects of currency depreciation:
Impact on businesses that export:
- Their products become cheaper for foreign customers
- This usually leads to increased sales overseas
- Export businesses generally benefit when their currency weakens
Impact on consumers:
- Imported goods become more expensive
- People have to spend more to buy the same international products
- This reduces purchasing power for foreign goods
Impact on businesses that import raw materials:
- Raw materials from abroad become more expensive
- This increases production costs
- Higher costs may offset any benefits from cheaper export prices
Impact on local businesses:
- They can compete more effectively against expensive imported goods
- May gain market share from foreign competitors
Worked Example: Currency Depreciation Impact
Using the same UK furniture company:
- Before depreciation: £100 furniture costs €120 for German customers
- After 10% depreciation: £100 furniture now costs €108 for German customers
- Result: German customers find the furniture cheaper, leading to increased sales
For the UK manufacturer importing wood:
- Before depreciation: $100 wood costs £80
- After 10% depreciation: $100 wood now costs £88
- Result: Higher production costs, reduced profit margins
Business uncertainty and planning challenges
Exchange rates constantly fluctuate, creating uncertainty for businesses involved in international trade. These fluctuations make it difficult for companies to predict their future costs and revenues, which complicates business planning and decision-making.
Since Brexit, the pound sterling has lost value against many other currencies. This has made UK exports cheaper for foreign buyers, but has also increased the cost of imported goods. Such significant changes in exchange rates can discourage businesses from engaging in international trade, as the unpredictability affects their profit margins and financial planning.
Common Challenge: Many businesses struggle with exchange rate risk management. Companies often use financial instruments like forwards contracts or currency hedging to protect themselves against unexpected exchange rate movements.
Real-world Impact: Studies show that exchange rate volatility can reduce international trade by up to 15%, as businesses become more cautious about entering foreign markets when currency movements are unpredictable.
Key Points to Remember:
- Strong currency = cheaper imports, more expensive exports
- Weak currency = more expensive imports, cheaper exports
- Exporters prefer a weaker currency to make their products more competitive abroad
- Importers prefer a stronger currency to reduce their costs
- Exchange rate fluctuations create business uncertainty and complicate international trade planning