The Times is publishing regular briefings to coincide with the Target Two Point Zero competition for sixth-formers, run with the Bank of England. The contest challenges students to play the role of the Bank’s Monetary Policy Committee and choose the best level of interest rates. This week: the role of the exchange rate.

–– How does the Bank track the pound and what has happened to it recently? The key indicator of the pound’s value used by the MPC is the Bank of England’s trade-weighted index. This measures its average exchange rate against a basket of currencies, taking into account the scale of UK trade in each of these currencies.

After rising sharply during much of last year to peaks above 106.0, recently the index has slipped back a little. At the close of business on Friday it stood at 103.0. This was 0.78 per cent up over the previous month, but down by a significant 1.71 per cent over the past three months, and by a lesser 0.43 per cent over the past year.

These trends mask different movements against the pound’s main rival currencies. In recent weeks, the pound sterling has risen dramatically against the dollar, as the US currency has come under sustained pressure. Sterling is at its highest level for 26 years against the dollar, having soared by 9 per cent from a year ago. Against the euro, the pound is 3.4 per cent weaker than it was a year ago.

–– How are exchange rates expressed? This can be confusing, so care is needed. In markets the pound’s rate against the euro is conventionally expressed in terms of pence per euro. So a weaker pound is shown by a higher figure for pence per euro – that is, it takes more sterling to buy a euro.

More simply, the dollar rate is usually quoted as dollars to the pound.

–– What is the impact of the exchange rate on exports? The exchange rate is the price of one currency expressed in terms of another, and is crucial to companies selling goods abroad. When the exchange rate rises, this makes exporters’ goods, priced in sterling, more expensive in foreign currency. So demand for these dearer exports drops, reducing overall demand in the economy. That should lower inflationary pressure. So a rising exchange rate tends to help to curb inflation, potentially allowing for lower interest rates. Conversely, a fall in the exchange rate typically boosts export demand, putting upward pressure on inflation and interest rates.

–– What about imports? A rise in sterling’s exchange rate will tend to make Britain’s imports cheaper, by boosting its purchasing power in foreign currency terms. This reduces costs for manufacturers and consumers. This is a second channel through which a rising pound puts downward pressure on inflation.

Again, conversely, a fall in the exchange rate makes imports more expensive, putting upward pressure on demand, inflation and interest rates.

–– How can movements in interest rates affect the exchange rate? Exchange rate moves can have knock-on implications for interest rates because of their effects on inflation. But changes in interest rates can themselves feed back into exchange rates, so the relationship between the two can be complex.

Conventionally, it is assumed that higher interest rates will usually tend to raise the exchange rate, and vice versa. Higher base rates boost returns on UK assets, attracting inflows of foreign funds, so stronger demand for pounds then pushes up the price – the exchange rate – of sterling.

In the real world things can be more complex. In some circumstances, a rise in interest rates can lead to an exchange rate fall. If, for example, a rate rise led investors to worry about UK growth prospects and move funds elsewhere, the exchange rate could drop.

www.bankofengland.co.uk/education/targettwopointzero

Explore Economics

• Autumn Budget 2007

• Budget 2008

• World Economic Forum

• The Times MPC

Times Recommends

• Bovis and Redrow axe close to 1,000 jobs
• Irate M&S shareholders demand fresh talks
• Investors rally to B&B amid fears of contagion