EXCHANGE RATES

An exchange rate is the rate at which one currency exchanges for another on
the foreign exchange market.  An example is £1:$1.50.

THE DEMAND FOR STERLING (£S)

Sterling is demanded for several reasons: 

•  To purchase UK exports – foreigners need sterling in order to buy our 

exports (although this is usually done through a third party such as the 

original importer).  As exchange rates rise so does the price of UK 

exports and therefore there should be a fall in exports meaning a fall in 

the demand for sterling.

•  Foreign investment in the UK – Nissan may want to build a new factory 

in the UK they need to spend pounds to do this.  Foreign investors may 

wish to put money in UK banks, perhaps attracted by high rates of 

interest. 

•  Speculation – Traders on the foreign exchange markets buy and sell 

sterling for profit.  A high exchange rate usually means demand for 

sterling is low as traders realise that the next movement is likely to be a 

fall in the exchange value.  This is the most important cause of short 

term exchange rate changes. 

As the exchange rate rises the demand for sterling falls and vice versa.

THE SUPPLY OF STERLING (£S)

Sterling is supplied for similar reasons: 

•  To purchase foreign imports – UK importers need to supply sterling in 

order to buy foreign currency so that they can buy their imported 

goods.  As the exchange rate rises, the price of imports falls, there 

should be an associated increase in imports, which leads to an 

increase in the supply of sterling to pay for them. 

•  UK investment abroad 

•  Speculation. 

As the exchange rate rises the supply of sterling will also rise and vice versa.

EQUILIBRIUM

The equilibrium exchange rate is shown below: 

The equilibrium is set where D = S at £1:$1.40.

CHANGES IN THE EXCHANGE RATE

A fall in the exchange rate is known as a depreciation.  A rise in the exchange 

rate is known as an appreciation.

Causes of depreciation include:

•  High UK inflation – UK will sell less exports because they are now too 

expensive (causing a fall in the demand for sterling).  The UK will buy 

more imports because they are now cheaper than UK goods (causing 

an increase in the supply of sterling).

•  A fall in UK interest rates – The UK will attract less foreign investment 

(causing a fall in the demand for sterling).  UK residents will now invest 

money in foreign banks which now have more attractive rates than 

domestic banks (causing an increase in the supply of sterling).

•  Speculation – Traders lose confidence in the pound expecting it to fall 

in value, this w  ill mean they will sell sterling (causing an increase in 

the supply of sterling) and they will not wish to buy sterling (causing a 

fall in the demand for sterling).

•  UK goods become less competitive – If foreigners no longer wish to but 

UK products due to quality issues, changes in tastes etc.  then the 

demand for sterling will fall.

LABOUR MARKETS

THE DEMAND FOR LABOUR

The demand for labour is the firm’s willingness to employ labour at each given 

wage rate.  As the wage rate rises the demand for labour will fall and vice 

versa.

The reasons for this are:

•  As wages increase firms will look to substitute labour for something 

cheaper i.e. capital (machinery). 

•  As wages increase, this puts up costs of production, which will in turn 

put up the price of the product, as prices rise demand falls, therefore 

with less of the product demand there will be less need for labour. 

THE SUPPLY OF LABOUR

The supply of labour is the employees willingness to work at each given wage 

rate.  As the wage rate rises more labour will be supplied and vice versa.

The reasons for this are:

•  Higher wages attract worker from other industries.

•  Higher wages attract people who are currently unemployed.

•  In the long term higher wages encourage people to train to work in that 

occupation.

EQUILIBRIUM

This is established where demand for labour equals supply of labour.  As 

shown in the following diagram: 

SHIFTS IN DEMAND AND SUPPLY

The demand for labour can shift to the right because:

•  Demand for the product has increased.

•  Labour productiveness has increased (through better training, 

education and technology). 

•  Price of capital increases making it relatively cheaper to employ labour.

The diagram below shows the effects:

An increase in the demand for labour also increases both wages and the 

quantity of labour employed.

The supply of labour can shift to the right because:

•  Increase in population.

•  Working conditions have improved (or deteriorated in an alternative 

industry).

•  Increase in training and education (long term).

The effects are shown below:

An increase in the supply of labour causes wages to fall and a rise in the 

quantity of labour employed.

EFFECTS OF A MINIMUM WAGE

A minimum wage is very similar to a minimum price.  The idea of a minimum 

wage is to guarantee a reasonable wage to workers in low paid industries.  

The diagram below shows the effects of a minimum wage: 

The minimum wage is set at Wm above the equilibrium wage W1.  The workers 

in the industry have indeed benefited from higher wages, but there are a few 

negative effects:

The minimum wage has cause a surplus (excess supply of workers), as far as 

the labour market is concerned this has created unemployment in the industry 

equal to Qs – Qd.

Q1 – Qd have now lost their jobs (these people were originally working before 

the minimum wage was introduced). 

EQUILIBRIUM

                                         EQUILIBRIUM

We can see on the diagram overleaf there is only one price where planned 

demand equals planned supply, this is known as the equilibrium price. This 

price is also known as the market clearing price, because all of the goods 

supplied to the market are bought (or cleared), but no buyer is left frustrated 

by his wish to buy. 

We can state that equilibrium occurs when demand equals supply. This can 

be shown on the graph where the demand curve crosses the supply curve

In the diagram below the price is above the equilibrium price. At this price 

firms are willing to supply more than consumers demand, giving rise to excess 

supply. When a shop holds a sale it implies there has been excess supply in 

the past, firms tried to sell the goods at a higher price in the past and failed. 

 In the diagram overleaf the price is below the equilibrium price. A this price 

consumers demand more than firms are willing to supply, leading to excess 

demand. This can occur in the sports car market where there is often a 

waiting list than can run into years.

SHIFTS IN EQUILIBRIUM

Shifts in demand and supply will cause the equilibrium position to change. In 

the diagram below demand has increased and shifted to the right. This will 

lead to an excess demand of a-b, suppliers will realise that they can charge 

higher prices. Price will keep rising until equilibrium is reached at P2  Q2 at 

point c. The opposite would occur for a shift in demand to the left.

In the diagram below supply has decreased and shifted to the left. This will 

lead to an excess demand of a-b, the resulting surplus will allow firms to raise their prices. Price will keep rising until equilibrium is reached at P2 Q2 at point 

c. The opposite would occur for a shift in supply to the right. 

If demand and supply both shift the resulting equilibrium will depend upon the 

size of their relative shifts.  It is possible to derive a number of different 

outcomes.