Exchange Rate in the UK: Empirical Examination of the Monetary Model

Subject: Finance
Pages: 5
Words: 1528
Reading time:
6 min
Study level: College


The exchange rate that prevails in the market is of great value to many government policy makers and economists in today’s world because of globalization. The determination of the exchange rate becomes of paramount importance due to the impact it has on the economic performance of the economy. Early the 1980’s the economy was liberalized and the exchange rate of any currency in most countries was allowed to be determined by market forces. However, in the 70’s and before there was a fixed exchange rate that prevailed. In such circumstances governments and other economists were able to predict the exchange rate that was prevailing in the market.

However in the recent times the exchange rate determination has been an issue of discussion in many economic forums because the prevailing e exchange rate is due to factors that determine economic growth of the economy.

The purpose of this paper is to determine and assess the factors to determine the dollar and sterling pound exchange rate as well as be able to know the model of exchange rate that is used. Through this we shall be able to understand economic fundamentals that produce successive macro economic management in the economy in the United Kingdom. Monetary model exchange rate determination has been employed in this research paper to conclude relating to this research paper. The paper begins with simple economic determining factors such as inflation, GNP, interest rates, Treasury bill rate, net capital outflow or inflow, income of citizens’ supply of money and many other factors.

Research background

Purchasing power parity theory explains how the exchange rate is determined in an open economy. According to research by Telatar and Kazdagh (1998) and Yazgan (2003) have emulated factors that determine the interest rate prevailing in an economy. In the literature they have stated that interest rate has a unique role in determining a behavior of the exchange rate in the economy. Johansen and Juselius (1990), have indicated the long term relationship between two currencies and the factors determining them. These writers have shown that monetary factors are a great determinant of the exchange rate that prevails in the market.

This research paper has been prompted by the fact that researches by various economists have shown co-integration between monetary model and the exchange rate. Purchasing power parity which is a law of one price applied to the price level as a whole as also been emulated as factors that determine the exchange rate that prevails in the market (Islam F. and Hasan M.S. 2006).

The current economic downtown experienced by the whole world has led to shocking fluctuation in the exchange rate that is prevailing in the market thus affecting every day to day commodity goods thus reducing the standards of living and posing a bleak future to some countries. The exchange rate that prevails in the market also determines the price of goods that are being imported and exported out of the country. It is through this backdrop this research paper has been prepared to determine the exchange rate that prevails( Islam F. and Hasan M.S. 2006).

Any business which engages in activities abroad exposes itself to the possibility of fluctuations in exchange rates which impose a risk on the operation over and above the basic commercial risk. Exchange rate fluctuations may equally as well lead to gains as losses but introduce an element of uncertainty which may be regarded as undesirable. This can either be accepted or may, at a cost, be eliminated (Johansen, S. 1992).

Foreign currency of all kinds is dealt with in foreign exchange markets which enable it to be bought and sold. The rate at which a deal could currently be made is known as the spot rate. The market also gives the facility to deal at forwarding rates; this means that at a rate is quoted which will be guaranteed for a deal at a future date, typically one month, three months or six months in the future. The forward rate is quoted at a premium or discount on the spot rate, depending on how the currency is expected to move (Johansen, S. 1992).

These rates would reflect that the dollar was expected to increase in value relative to the pound. Buying forward will thus cost more than buying spot for a currency expected to appreciate against the pound but less for a currency expected to depreciate (Johansen, S. 1992).

It may look like a paradox that on the one hand most people say that it is impossible to predict exchange rates while on the other hand those same people engage in forwarding transactions and commit themselves to specific exchange rates far ahead into forward transactions allows you to do (Telatar, E. and Kazdagli, H. 1998).

Each of the two companies in figure C. I am confronted with an unattractive business opportunity. Each business opportunity has a low margin and is risky. In each case sales are invoiced in a foreign currency and their proceeds are dependent on the future exchange rate. When considering the historical currency fluctuations both business opportunities should probably be rejected (Johansen, S. 1992).

There is however a simple solutions for making these two business opportunities much more attractive. It just requires that the two companies meet – directly or through an intermediary – and agree to exchange, or swap, the proceeds of their sales at the forward rate mentioned in the figure (Telatar, E. and Kazdagli, H. 1998).

U.S investors choose not to own foreign equities in local currencies and prefer to settle their international trade in U.S dollars. This introduces what can be either another element of risk or a positive foreign-exchange “kicker” into the performance equation, depending on changes in exchanges rates after the time of purchase. Foreign-exchange rates fluctuate for some reasons:

  • The relative strengths of the respective economies – growth in gross domestic product, balance of payments position, the rate of inflation e.t.c
  • Real interest rate differentials
  • Technical (supply and demand) and seasonal factors
  • Political and regulatory developments.

Exchange rate vitality has captured the headlines with increasing frequency in recent years – first with the strong upward surge of the U.S dollar vis-à-vis the major currencies and lately with its treading in the opposite direction (Islam F. and Hasan M.S. 2006).

When the dollar strengthens investing overseas becomes cheaper. However a dollar investor’s return on capital is diminished if the dollar appreciates further. The reverse is true when the dollar weakens; investing abroad becomes more expensive, yet a decline in the U.S dollar relative to the home currency of the foreign holding will enhance returns (Islam F. and Hasan M.S. 2006).

Rational of the topic

The study will be of help to the researcher, by demonstrating him/her determinants of exchange rate and on how they affect economic growth of a country. This is because Exchange rates’ are pillars of economic growth for nations. Researching and assessing the determinants exchange rate of sterling pound against the dollar will enable the researcher, policy makers, economics students and economist understand exchange rate determination and how to control it using on factors such as inflation, supply of money, interest rate, treasury bill and other factors and this are the clear justification for the study. The study of its determinants by the researcher is important because it will help him/her grow professional and it will be of value to;

  1. Future researchers on exchange determinants
  2. Management of companies that engage in international business.
  3. Governments

Because the objective of the study will be;

  1. To carry out empirical test of exchange rate determination in U.K using the monetary model approach.
  2. To critically analyze the role of expectations in Pound and Dollar rate dynamics
  3. To investigate the relations between exchange rate and some economic variable (inflation, interest rate, consumption and money supply as variables)
  4. To ascertain the factors influencing exchange rate movements in UK.


There are two methods of research/ data collection in research papers: that is quantitative and qualitative. Quantitative method is applicable where the problem is known, the problem is based on theories and can be measured in numbers. The analysis can be done on tables, graphs, pie charts, gnat charts and other statistical theories and it relies on assumptions. There are some methods which are under quantitative methods. These include surveys, experiments and quasi experiment. Qualitative method is different from quantitative because it is used to measure human feelings, attitudes and perceptions.


In this research question both methods will be used. This is because most data will be collected from books and history internet resources. The problem of this research question is how and which direction the research problem will take. There is always a connection between the research from the research question and the methods or the collection tools used, since it influences the conclusions and the recommendations. Qualitative method will be used to collect the writers opinions, attitudes, perceptions and feelings on the relationship between corporate social responsibilities and the fast food industries in the two countries. Quantitative method will be used in collecting facts in numerical at the same time; analysis of the data will be done in the form of tables, graphs and other statistical tools.


Islam F. and Hasan M.S. (2006); The Monetary Model of the Dollar-Yen Exchange Rate Determination: A Cointegration Approach; International Journal of Business and Economics, Vol. 5, No. 2, 129-145.

Johansen, S. (1988). Statistical analysis of cointegration vectors, Journal of Economic Dynamics and Control, 12, 231-254.

Johansen, S. (1992); Determination of cointegration rank in the presence of a linear trend, Oxford Bulletin of Economics and Statistics, 54/3, 383-397.

Johansen, S. (1995), Likelihood-based Inference in Cointegrated Vector Autoregressive Models, Oxford University Press.

Johansen, S. and Juselius, K. (1990). Maximum likelihood estimation and inference on cointegration-with applications to the demand for money, Oxford Bulletin of Economics and Statistics, 52, pp.169-210.

Telatar, E. and Kazdagli, H. (1998). Re-examine the long-run purchasing power parity hypothesis for a high inflation country: the case of Turkey, Applied Economics Letters, 5, 51-53.

Yazgan, M.E. (2003). The purchasing power parity hypothesis for a high inflation country: a re-examination of the case of Turkey, Applied Economics Letters, 10/3, 143-147.