Discuss and analysis the movements in value of the Euro against the pound since January 2008
The value of Euro varies with time by a floating exchange rate against British Pound (GBP). Hence, the exchange rate influenced the value of Euro against GBP and law of one price is assumed. Theories such as the relative Purchasing Power Parity and the fisher effect illustrate the impact of the inflation and the interest rate between two countries on the value of the currency. The asset market model is also another instrument to analyse the movement of a currency. The constraints of using these models are those theories all assumed perfect efficiency of market and the increasing role ...view middle of the document...
(Inflation in the euro area Fig2) (Inflation in the UK Fig3)
The world economy was dragged by the financial crisis in the USA and Iceland. In contrast to the Euro area, the UK had suffered more.
The Euro was at 0.74, its weakest point at the beginning of 2008. The reduction of interest rate announced by Bank of England and the UK debt level which was greater than 40% of GDP made the value of GBP depreciated significantly and dropped by 27% (Fig 4). The inflation rate of the Euro area and the interest rate of the UK affected the value of Euro. The inflation rate of EU dropped to 1.6% (Fig2), whilst the UK’s rose over 3%. This made the euro exports unattractive. However, because the UK had the similar trend in inflation (Fig3), the overall effect was then offset in the beginning of 2008. This explained the reason why the movement of Euro was fairly constant from April to October. The value of euro has maintained at the range of 0.7901 to 0.8130.
Source : ECB, Annual Report2009 (Fig4)
According to the Interest Rates Review 2008, as the Bank of England tried to counteract the widespread credit crisis on the housing market, the interest rates cut by a quarter of a point to 5% and dropped further towards the end of 2008. The interest rate of EU, 6.5% was relatively higher than 5% which caused more hot money to flow into the EU economy. As the demand of Euro increased, the value of Euro appreciated. Nevertheless, Euro did not have radical increase in value. The effect was offset by the decline in German retail sales and the performance of the French Trade Balance.
The value of Euro rose 26.26% from 0.7751 to 0.9785 from October to December2008. The rise in value of euro was caused by the chain effect of the credit crunch, the crisis of Iceland and the relative low interest rate of the UK. The Credit Crunch has brought the world economy into recession as the US economy has a huge effect on the world economy. The Iceland financial crisis has worsened the economy of the UK. This is because more than 100 UK local authorities such as the council of Kent and Transport for London had invested over £840 million cash in the three major Iceland Banks. The collapse of the banks in Iceland damaged the economy across the UK which led to a depreciation of value of GBP. In contrast, Russia has granted Iceland a EUR 4 Billion loan. Iceland was considered to join the European Union. These boosted the demand of Euro which drove the value of Euro rose to the highest point 0.9786 toward the end of year.
In addition, the inflation rate of EU dropped to 1.6% (Fig2), whilst the UKs rose over 3% at the end of 2008. This drove the value of Euro to the highest point 0.9786 toward the end of year. EU experienced a lower inflation rate relatively to the UK. Importers from the EU became more prices competitive with the UK.
GBP fell after the figures added to growing expectations that...