[This post was written before the bottom fell out of the market--the Great Recession.  Since the US's economy has weathered the storm much better than Europe, the exchange rate has settled near £1 = $1.50 or $1.60.  This obviously makes the trip to the UK much more reasonable.  I still stand by the long-run expectations, though it will take many years before that comes to fruition.]

£1 = $2+. The Pound has hit a 26 year high against the Dollar. This means that the cost of living keeps going up for those transferring money to the UK from the US. For those of you in the biblical studies world, these financial machinations may be confusing. Since I spent a former life in finance and accounting, I thought I’d give you the basic supply-demand forces that drive changes in currency exchange rates. As with stock markets, speculators also drive price changes as well, especially over the short term, but eventually the exchange rates reflect market fundamentals.

Short Term
In the short term, interest rate differences (actual and expected) between countries are the fundamental cause for movement in the exchange rate. If interest rates increase in a country, it becomes more enticing to invest money there because you get a higher return on your money. Thus there is a greater demand for that currency, which raises its relative value.

While there are many different causes to changes in national interest rates, a main influence is the central bank* lending rate. The Federal Reserve in the US currently has the Federal Funds Rate set at 5.25%, and the Bank of England also currently has rates set at 5.25%. However, inflation (i.e., an increase in prices) is currently lower in the US, so the Fed is expected to drop rates. At the same time, inflation in the UK is higher than the BoE target, so interest rate increases are expected in the UK. Thus, the pound is increasing in value vis-a-vis the dollar.

Long Term
In the long term the $ is losing it’s strength as ‘the’ dominant world currency for several reasons. As a result, demand is slowly dropping for the $, which results in a lower value. With the introduction of the Euro (€) several years back, there is another stable currency that other central banks are beginning to also use as a reserve currency. But even more important is the accumulated years of current account deficits run by the US, which goes hand in hand with the ever increasing federal debt in the US. The current account deficit is caused by the fact that the US imports a much larger amount than they export; think consumer economy. We pay for all those goods with $’s, so every year there is a net outflow of $’s to other countries. Eventually, they will have so many $’s that it’s value will decline. Also, the federal government continues to run deficits and borrow more money. Again, when the debt gets high enough, other countries that buy our bonds begin to consider those $-bonds more risky. Think of China, they sell us lots of goods, and they use much of the $’s they get to buy US bonds. They’ve got to do something with all those $’s, but the diminishing marginal utility of the $ will eventually kick in.

In the end, the cards are stacked against the $ because of our spending habits and the increase in debt–from both consumers and the federal government. The only reason that the fall in the $ hasn’t been quicker and stronger is because the sustained stability of the US economy and the $’s use as an international currency. But, as I mentioned with the € and it’s relative strength, the universal use of the $ is being challenged. The solution for the US: buy less, borrow less. Somehow that doesn’t seem to be the path the US is going to follow.

*The central bank of a country is typically partially independent of the government so economic decisions can be determined separately from political forces. They generally have two main goals: price stability (limiting inflation and/or deflation) and secondarily encouraging economic growth. Higher interest rates generally help fix the first issue, and lower interest rates generally help with the second. In a time of steady growth, a rate of about 4% is considered neutral, in that it works evenly toward both goals. Monetary policy of the banks (e.g., how much money they print) also influences currency values.