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Here’s how the value of the pound is figured out


Look at UK newspaper headlines, especially in these Brexit days of 2018, and you’ll start to get the impression that something odd is happening to the pound. It “climbs”, “collapses”, “shakes”, “jumps”, “hovers”, “spikes” and “slumps” - and that was just this week.

But pop into your local British cafe for your morning macha-chai-soy-latte (or, you know, filter coffee if you’re outside Shoreditch) and you’ll find that not only have prices have stayed the same, the pound coins in your wallet are just as round and shiny as ever.

So what are all these newspapers going on about? And when might you actually feel the effect in your pocket?


Currencies are always compared to other currencies

When someone talks about the pound rising/falling, or strengthening/weakening, or becoming more expensive/cheaper, what they actually mean is that the number of pounds you could swap for another type of money has changed.

If you’ve been on holiday or bought something from abroad, you’ll be familiar with swapping currencies, or, to use the proper term, exchange rates. And if you frequently use exchange rates, you might have noticed that they can change. Had you headed to New York in December 1990, you could have got almost $200 for every £100 you swapped. Go today, and you’d get $125 for every £100.

If a person talking about the pound’s exchange rate doesn’t say which currency they’re comparing it to, a pretty safe bet is to assume it’s the dollar, because America is such a big world player that their currency is often used as the default setting (least they’re always humble about it, huh?). The pound is also quite often compared to the euro, and you might also see it set against a “currency basket”. That’s a combo of several different currencies, whose value is averaged out.


Who decides what the exchange rates are?

Lots of countries, including the UK, the USA and the EU have “floating currencies” (also called “floating exchange rates”). That means the money you get when you swap these currencies is basically figured out based on how much everyone wants the currencies in question.

Say in summertime lots of people want pounds more than they want dollars, and in winter they want dollars more than they want pounds. You’d be able to swap pounds for more dollars in summer than in winter. The economic term for this is supply and demand.

But what makes people want certain currencies at certain times? Well, all sorts of things. A country’s currency could be super desirable because lots of people want to go on holiday there, or buy loads of stuff from it, or have that currency as a backup in case local politics mucks up the currency in their own country (like when all the prices in Zimbabwe went up so much that a loaf of bread costs like millions and millions of Zimbabwe monies).

If that’s still confusing, picture this: you and I are in a shop which sells apples and oranges. But it only accepts blue tokens for apples, and only red tokens for oranges. (Yeah, it’s a proper weird shop, bear with us.) You have ten red tokens, and I have ten blue. We both want both apples and oranges. The obvious solution is to swap some tokens. But how should we do so?

One blue token for one red token might seem like a good answer. But what if an apple cost five blue tokens to buy, while an orange cost just one red token? If you give me half your red tokens, you can now only buy six pieces of fruit (five oranges and one apple), whereas at the beginning you could buy ten. You might not think that’s a very good deal.

Or, what if we both really love apples but aren’t so bothered by oranges? I might think that it’s not worth giving up my blue apple-buying tokens until you make me a really good offer - like all ten of your red tokens for five of my blue ones.

Or what if I had some info that made me have a hunch that next week the shop was going to announce one red token would now buy five oranges instead of one. That would make red tokens a much better thing to own and worth stockpiling. So I might be willing to offer you all my blue tokens for even one red token. (In this real world, this is called currency speculation, and people do it when they’re trying to make money from swapping currencies).


How Brits do exchange rates now is really different to 50 years ago

If floating exchange system sounds a bit random, that’s probably because they were invented quite recently in order to solve some problems that arose from a different way of working out exchange rates: currency pegging. A currency is “pegged” (or “fixed”) when it has a set exchange rate that doesn’t change. So the UK could peg the pound to the dollar by saying $1 is now worth £1, no exceptions, forever and ever, case closed.

From World War II until the ‘70s, currency pegging was all the rage under something called the Bretton Woods system. Bretton Woods worked like this: America decided that each dollar was worth a certain, fixed amount of gold. Most other countries then decided that each unit of their currency was worth a certain, fixed amount of dollars. The idea was that this system meant everyone always knew where they stood in terms of exchange rates, and that might help everyone get along a bit better. (This was post-World War II, remember).

Some countries still use currency pegs today. Barbados and Saudi Arabia peg their currency to the dollar, for example, and Denmark pegs its to the euro. But the Bretton Woods system has long since collapsed. Short version of the story: America needed a mahoosive amount of gold to keep the system working (because they had to be able to exchange every dollar in the world for gold if asked) and realised it just wasn't possible to own that much bling.


Exchange rates are super political

Remember how we said floating exchange rates are set by supply and demand, or how much people want each currency? Well, that ‘want’ tends to be closely linked to the political situation in the country. Every time a big political thing happens in a country, its currency goes up or down. That’s why there’s been so much chatter about what the pound is doing everytime there’s a new Brexit-related announcement in Britain.

Say Brexit results in fewer people wanting to live in the UK, or take a holiday there, or buy stuff from it, or set up a shop there. That means fewer people wanting to own pounds. And because these people who have decided against spending money in the UK will probably still want to live, holiday, buy stuff and set up shops somewhere they will simultaneously want to get their hands on more of that place's currency. There's a good chance that for a lot of people that somewhere would be the EU, and that other currency euros. So demand for euros goes up, demand for pounds goes down, and the end result is that everyone gets fewer euros per pound (and more pounds per euro) than they would have done before Brexit.

Plus, you know how we said some people like to speculate, or place bets, on how an exchange rate might change? Well, if these speculators think that Brexit will make people want fewer pounds than they did before, they're likely to try and make money by swapping lots of pounds for another currency now, before the pound drops. Imagine if you bought €100 for £100 today and then tomorrow the pound dropped so much that €100 is worth £200. If you converted your €100 euros back to pounds you'll have doubled your money. That's basically what these speculators are trying to do.

The odd thing about this currency speculation stuff is that even if investors aren’t right about how much ordinary people will want a currency (maybe everybody will want to set up shop in post-Brexit Britain), they can fulfil their own prophecy because by ditching the ill-favoured currency themselves, they are dampening demand. If that sounds kinda crazy to you, well, welcome to the world of financial markets, or more specifically FOREX (Foreign Exchange).


What have exchange rates got to do with the economy?

Lots! Exchange rates are actually pretty important in your day-to-day life.

  • Tourism

If you’re planning a holiday abroad, where you go and how much you spend while you’re there will depend on the exchange rate. If you pick somewhere which has a currency that is weak against the pound, you’ll get some extra bang for your buck and might be able to afford that snazzy hotel upgrade.

And it works the other way too - if the pound is weak against the euro, people from eurozone countries are more likely to decide it’s a good time to go check out Big Ben (although heads up if you’re a wannabe tourist reading this in December 2018 - it's currently surrounded by scaffolding).

  • Immigration

One of the big motives for people moving to another country is to be able to earn more money than they could back home. That tends to be because the destination country is richer / has things like minimum wage laws rather than because of the currency exchange rate, but a lot of economic migrants like to send money back to families or friends in their native country (called remittances).

Exchange rates determine how much local currency those remittances can be turned into, so for some immigrants there is an incentive to choose a country with as strong a currency as poss.

This is especially true for flexible and/or seasonal workers. EU fruit pickers from non-euro countries, for example, might decide to spend the next summer in Spain rather than the UK if the euro is stronger against their local currency than the pound.

  • Prices of stuff in shops

Most businesses try to make a profit, which means that if the cost of making/getting the stuff they sell goes up, they need to put up prices or make less profit. And if they buy/get stuff from abroad, exchange rates will make their costs (and therefore prices) change. If the pound is weak against the euro it becomes more expensive for UK supermarkets to buy French wine, so Brits might end splashing out more for their fav bottle of vino.

  • Businesses who sell stuff abroad

If businesses sells stuff to countries that has a stronger currency than they do, they might end up with lots more sales. Say dollars get stronger against the pound. Americans can now get British stuff cheaper than before, because each of their dollars can exchanged for more pounds. So they have a financial incentive to stock up on Marmite and scotch eggs.

The stuff a country sells abroad is known as it’s exports, which is why you might see politicians and businesspeople talking about how a weak pound will be good for export rates.

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