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Analyze The Determinants Of The Gbp Nominal Exchange Rate And Its Future Prospective

1320 words - 5 pages

Currency, like any other commodities, has a price, and sterling or Great Britain Pound (GBP) is no exception. Obviously, the price of the pound has depreciated against the US dollar during a long term, but it has appreciated against the US dollar over a short period of time. Indeed, according to the World Bank Data (2010), GBP price dropped slightly against that of the USD from 1.65 on September 1st 2009 to 1.55 on August 15th 2010. However, this survey also reveals that the price sterling to dollar has risen steadily between1.45 and 1.55 since last month. So, what causes the fluctuation of the GBP nominal exchange rate has provoked a heated discussion. The purpose of this essay is to explore the determinants of sterling nominal exchange rate and forecast its future trend. Firstly, it will give definition of nominal exchange rate compared to real exchange rate. Secondly, three factors that decided the GBP nominal rate of exchange will be analyzed. Finally, it will predict the future tendency of sterling exchange rate in accordance with the determinants.

It is common to classify the exchange rate into two types, nominal exchange rate and real exchange rate. Nominal rate of exchange defined as the value of the domestic currency in relation to a foreign currency without consideration of the inflation rate (Piana, 2001). Similarly, as Basak and Gallmeyer (1998) maintained that nominal exchange rate is expressed as number of units of home currency that can purchase a unit of another currency. For example, if the nominal exchange rate between the GBP and the USD is 1.55, then one pound will purchase 1.55 dollar. By contrast, real exchange rate takes inflation into consideration, which reveals how much the goods and services in the home nation’s country can be exchanged for the counterpart in foreign country, and it is represented by the following equation: real exchange rate = nominal exchange rate + inflation rate(Chinn, 2006). This concept is clearly illustrated with an example. Imagine U.K. has an inflation rate of 5% while U.S. inflation rate is 2%, then Britain has now a currency whose real value is 5%-2%=3% higher than its nominal one.

In fact, nominal exchange rate is the one which is daily reported by the newspaper, and it is mainly decided by three factors. First of all, interest rate has exerted great influence on sterling nominal rate. As Drab (2005) claimed that “nominal exchange rate react to changes in the relative interests rate between nations.” That is to say, the different interest rates of two countries will lead to the fluctuation of nominal exchange rate, and the capital will flow from the nation whose interest rate is comparatively low to another that with higher rate. For instance, if America and Britain both have interest rates of 5%. Now, the U.S. raises its interest rate to 10%. Of course, investors want to make money as much as possible. Thus, they would like to transfer their British pounds into America dollars and...

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