External environment theory

External environment illustration

Exchange rates

Money is demanded in order for it to be used to buy and sell goods and services. The same applies to international currency. Foreigners buy pounds in order to buy British and other goods and services. The exchange rate is the rate at which the £1 will exchange with other currencies. For example in the Spring of 2004, the £1 exchanged for about 1.40 euros. Let us assume that one pound exchanges for 1.40 euros. Demand for pounds may come from two sources. Firstly, when British producers sell goods in France they will want payment in pounds, but will often be paid in euros. Secondly, French citizens who want to purchase shares in British assets, e.g. shares in Manchester United plc or Cadbury Schweppes, must change their euros into pounds to buy them.

On the other side of the equation, a supply of pounds may arise in the foreign exchange market because UK firms and households want to purchase French goods, and because UK citizens want to purchase French assets.

To make the maths in this case study easier we will assume that £1 initially exchanges for 2 euros. If Cadbury Schweppes sells a bar of chocolate for 50p in this country, this will cost the French consumer 1 euro. However if the £ falls in value to £1.50 euros the same type of chocolate bar will only cost 75 cents (0.75 euros). We would therefore expect Cadbury Schweppes to sell more chocolate bars and other goods in the European Union at the lower exchange rate.

We can therefore make a generalisation that a larger quantity of pounds will be demanded at lower euro-sterling exchange rates.

You should be able to see that if the £ rises relative to the euro it will become harder for UK firms to sell into European Union markets.

The exchange rate is the rate at which one currency will exchange for other international currencies. This rate will vary over time depending on the relative strength of the trading economies of the countries considered.