An appreciation in the exchange rate can occur for several reasons. The most significant reasons include higher interest rates and lower inflation. An exchange rate appreciation can have a significant impact on a country’s economic growth and inflation, so it is important to understand what can cause an exchange rate appreciation.
1. High interest rates. If interest rates rise, it becomes more attractive to save money in UK banks and in UK financial securities such as bonds. Therefore, this causes a higher demand for sterling to deposit money in the UK. This is called “hot money flows.” The increased demand for sterling causes an appreciation of the exchange rate. It is a significant factor due to the high volume of foreign currency that is transferred between countries to take advantage of the differences in interest rates.
2. Inflation rates. If inflation in the UK is lower than elsewhere, it makes UK products relatively more attractive. So there is an increase in demand for UK exports and therefore higher demand for sterling will cause appreciation. This is an important factor in the long run.
3. Speculation. Many exchange rate movements are due to speculation. If people think that an exchange rate may increase in the future, then they will buy now to try to make a profit. Therefore, this speculative purchase causes significant fluctuations in the exchange rate. The attitude of forex traders towards an economy is very important in determining the exchange rate.
4. Increased competitiveness. This is related to lower inflation. If a country becomes more competitive due to higher labor productivity, there will be more demand for UK goods and the exchange rate.
5. Current account surplus. This means that the value of imports (of goods and services) is less than the value of exports. Therefore, more currencies enter the country than leave. (although it can be offset by a surplus in the financial/capital account.