Exchange Rates

What you'll learn

Exchange rates are fundamental to international trade and affect businesses, consumers, and governments worldwide. This revision guide covers all testable content on exchange rates in the Pearson Edexcel International IGCSE Economics specification. You'll learn how exchange rates are determined, the difference between floating and fixed systems, and how currency value changes impact economies.

Key terms and definitions

Exchange rate — the price of one currency expressed in terms of another currency

Appreciation — an increase in the value of a currency under a floating exchange rate system

Depreciation — a decrease in the value of a currency under a floating exchange rate system

Revaluation — an increase in the value of a currency under a fixed exchange rate system, decided by the government

Devaluation — a decrease in the value of a currency under a fixed exchange rate system, decided by the government

Floating exchange rate — a system where the value of a currency is determined by market forces of demand and supply

Fixed exchange rate — a system where the value of a currency is set and maintained by the government or central bank at a particular level against another currency

Foreign exchange market — the global market where currencies are bought and sold

Core concepts

How exchange rates are determined

The exchange rate between two currencies is determined by the interaction of demand and supply in the foreign exchange market. When we discuss the exchange rate for the British pound (£), for example, we examine what determines demand and supply for pounds.

Demand for a currency increases when:

• Foreign consumers want to buy exports from that country (they need the currency to pay for goods)
• Foreign investors want to invest in the country (purchasing property, shares, or setting up businesses)
• Speculation occurs that the currency will rise in value (traders buy the currency hoping to sell it later at profit)
• Interest rates in the country rise (attracting foreign savers who need the currency to deposit money)
• The country becomes more attractive for tourism (foreign tourists need the currency)

Supply of a currency increases when:

• Domestic consumers want to buy imports (they supply their currency to obtain foreign currency)
• Domestic firms want to invest abroad (they supply their currency to obtain foreign currency)
• Speculation occurs that the currency will fall in value (traders sell before the value drops)
• Interest rates abroad are relatively higher (domestic savers supply the currency to save abroad)
• Domestic tourists travel abroad (they supply their currency to obtain foreign currency)

In a floating exchange rate system, if demand for pounds increases relative to supply, the pound appreciates. If supply increases relative to demand, the pound depreciates. The exchange rate adjusts continuously based on these market forces.

Floating vs fixed exchange rate systems

Floating exchange rate systems operate in major economies including the UK, USA, Japan, and most Caribbean nations. The government and central bank do not intervene to set the exchange rate—it fluctuates daily based on market forces.

Advantages of floating exchange rates:

• Automatic correction of trade imbalances (depreciation makes exports cheaper and imports dearer, improving the trade balance)
• No need for large foreign currency reserves
• Monetary policy independence (government can set interest rates based on domestic priorities)
• Market forces allocate resources efficiently

Disadvantages of floating exchange rates:

• Uncertainty for exporters and importers (firms cannot predict future exchange rates accurately)
• Speculation can cause volatility
• May not automatically correct trade deficits if demand is price inelastic
• Can lead to inflation if the currency depreciates significantly

Fixed exchange rate systems require the government or central bank to maintain the currency at a set value. The Eastern Caribbean dollar is fixed to the US dollar, and historically the Chinese yuan was fixed (now managed). The central bank must buy or sell foreign currency reserves to maintain the fixed rate.

Advantages of fixed exchange rates:

• Certainty for international trade and investment
• Helps control inflation (prevents import prices rising due to depreciation)
• Imposes discipline on government economic policy
• Encourages foreign investment due to stability

Disadvantages of fixed exchange rates:

• Requires large foreign currency reserves
• May maintain an exchange rate that damages competitiveness
• Cannot use exchange rate changes to correct trade imbalances
• Vulnerable to speculative attacks
• Removes monetary policy independence (interest rates must support the fixed rate)

Effects of appreciation and depreciation

When a currency appreciates (or is revalued under a fixed system), the effects include:

On exports:

• Exports become more expensive in foreign currency terms
• Quantity demanded of exports falls (assuming demand is price elastic)
• Export revenue may fall
• Exporters face reduced international competitiveness
• Example: If £1 = $1.20 rises to £1 = $1.40, a £100 UK product rises from $120 to $140 for American buyers

On imports:

• Imports become cheaper in domestic currency terms
• Quantity demanded of imports rises
• Import expenditure depends on price elasticity of demand
• Consumers benefit from lower prices
• Example: If £1 = $1.20 rises to £1 = $1.40, a $100 American product falls from £83.33 to £71.43 for UK buyers

On the current account balance:

• Trade balance likely worsens (exports fall, imports rise)
• Depends on price elasticity of demand for exports and imports
• The Marshall-Lerner condition states that the trade balance improves from depreciation only if (PED exports + PED imports) > 1

On inflation:

• Import prices fall, reducing cost-push inflation
• Lower imported raw material costs reduce production costs
• Reduced inflationary pressure overall

On economic growth and employment:

• Export industries may decline, reducing output and employment
• Import-competing industries face stronger foreign competition
• Overall economic growth may slow

When a currency depreciates (or is devalued), the opposite effects occur:

• Exports become cheaper and more competitive internationally
• Imports become more expensive
• Trade balance may improve (if demand is sufficiently price elastic)
• Inflation rises due to higher import prices
• Export industries expand, potentially increasing employment and growth

The J-curve effect

The J-curve effect explains why a depreciation may initially worsen the trade balance before improving it. This occurs because:

In the short run:

• Existing contracts are already agreed in foreign currency
• Quantity of exports and imports cannot adjust immediately
• Import prices rise immediately, increasing import expenditure
• Export revenue does not increase yet (quantities unchanged)
• Trade balance worsens

In the long run:

• Contracts can be renegotiated
• Consumers and firms respond to new relative prices
• Quantity of exports rises (cheaper abroad)
• Quantity of imports falls (more expensive at home)
• Trade balance improves (assuming sufficient price elasticity)

When plotted on a graph with time on the x-axis and trade balance on the y-axis, the pattern resembles the letter J—initially falling then rising. This is particularly relevant for Caribbean economies heavily dependent on imported goods where short-run elasticity is low.

Exchange rates and government objectives

Governments must consider exchange rate effects when pursuing macroeconomic objectives:

Economic growth: Depreciation supports export-led growth but risks inflation; appreciation may slow growth but controls inflation.

Low unemployment: Depreciation boosts export industries and employment; appreciation may reduce jobs in export sectors.

Price stability: Appreciation helps control inflation through cheaper imports; depreciation causes imported inflation.

Current account balance: Depreciation improves competitiveness; appreciation worsens the trade balance.

Conflicts arise because a policy benefiting one objective may harm another. For example, allowing depreciation to improve the current account may conflict with maintaining low inflation. Governments in small open economies like Caribbean nations face particular challenges as they depend heavily on imports for essential goods and energy.

Worked examples

Example 1: Calculating exchange rate changes (4 marks)

Question: In January, the exchange rate was £1 = $1.30. By July, it had changed to £1 = $1.44.

(a) Identify whether the pound has appreciated or depreciated. (1 mark) (b) Calculate the percentage change in the pound's value. (2 marks) (c) Explain one effect this change would have on UK exporters. (1 mark)

Mark scheme answer:

(a) The pound has appreciated (1 mark) — £1 now buys more dollars.

(b) Change = (1.44 - 1.30) / 1.30 × 100 = 10.77% (or 10.8%) appreciation (2 marks: 1 mark for correct method, 1 mark for correct answer)

(c) UK exports become more expensive in dollar terms (or for American buyers), so the quantity demanded of UK exports is likely to fall (1 mark for explained effect). UK exporters lose price competitiveness in international markets (alternative acceptable answer).

Example 2: Explaining effects of depreciation (6 marks)

Question: Analyse how a depreciation of the Jamaican dollar might affect Jamaica's economy. (6 marks)

Mark scheme answer:

A depreciation makes Jamaican exports cheaper in foreign currency terms, which should increase the quantity demanded of exports such as bauxite and tourism services (1 mark for mechanism). This could improve Jamaica's trade balance, as export revenue rises (1 mark for effect), provided demand is price elastic enough (1 mark for condition/evaluation).

However, depreciation makes imports more expensive in Jamaican dollars (1 mark for mechanism). Since Jamaica imports oil, machinery, and food, this will increase costs for firms and prices for consumers (1 mark for effect). This could cause cost-push inflation, reducing real incomes and living standards (1 mark for developed effect).

The overall impact depends on the price elasticity of demand for exports and imports. In the short run, the trade balance may worsen due to the J-curve effect (1 mark for evaluation—would need 6 distinct marks from above).

Example 3: Floating vs fixed systems (8 marks)

Question: Evaluate whether a floating exchange rate system is better than a fixed exchange rate system for a small Caribbean economy. (8 marks)

Mark scheme answer:

A floating exchange rate offers automatic adjustment to trade imbalances (1 mark). If the country runs a trade deficit, its currency depreciates, making exports cheaper and imports dearer, which should reduce the deficit over time (1 mark for development). This removes the need for large foreign currency reserves that the central bank must hold under a fixed system (1 mark).

Additionally, floating rates give the government monetary policy independence (1 mark). The central bank can set interest rates based on domestic inflation and unemployment rather than to maintain a fixed rate (1 mark for development). This flexibility is valuable during economic crises.

However, floating rates create uncertainty for businesses engaged in international trade (1 mark). Import and export firms cannot predict future exchange rates, making planning difficult and potentially discouraging foreign investment (1 mark for development). Small Caribbean economies depend heavily on tourism and imported goods, so this uncertainty could be particularly damaging.

Fixed rates provide stability and certainty (1 mark). The Eastern Caribbean dollar's fixed rate against the US dollar has encouraged trade and investment with the USA (1 mark for development). Fixed rates also impose discipline on government policy, preventing excessive inflation (1 mark).

Overall, the better system depends on the specific circumstances. A small economy heavily dependent on one trading partner (like the USA) might benefit more from a fixed rate providing certainty (1 mark for judgement). However, an economy needing flexibility to adjust to external shocks might prefer a floating system (1 mark for balanced judgement—8 marks maximum).

Common mistakes and how to avoid them

• Confusing appreciation/depreciation with revaluation/devaluation: Appreciation and depreciation occur under floating systems due to market forces; revaluation and devaluation occur under fixed systems due to government decisions. Always check which exchange rate system applies before using these terms.

• Assuming depreciation automatically improves the trade balance: The effect depends on price elasticity of demand for exports and imports. If demand is inelastic, depreciation may worsen the trade balance initially (J-curve) or even long-term. Always mention the Marshall-Lerner condition or elasticity when discussing trade balance effects.

• Forgetting to specify which currency: When discussing appreciation, state which currency has appreciated. "The exchange rate increased" is unclear—increased from £1 = $1.20 to £1 = $1.40 means the pound appreciated, but increased from $1 = £0.83 to $1 = £0.71 means the pound depreciated.

• Ignoring time lags: Exchange rate changes don't affect trade immediately. Contracts take time to adjust, and consumers and firms need time to respond. Reference short-run versus long-run effects or the J-curve effect in evaluation.

• One-sided answers in evaluation questions: Discuss both advantages and disadvantages, or both positive and negative effects, then reach a supported judgement to access the highest mark levels.

• Confusing causes and effects: Distinguish between factors that cause exchange rate changes (e.g., increased export demand causes appreciation) and effects of exchange rate changes (e.g., appreciation causes export prices to rise).

Exam technique for "Exchange Rates"

• Identify/state questions (1-2 marks): Give precise terminology without explanation. "The pound has appreciated" or "A fixed exchange rate system" earns the mark. No development needed.

• Explain/analyse questions (4-6 marks): Use chain reasoning—state the change, explain the mechanism, give the effect, and add a further consequence. For example: "Depreciation makes exports cheaper → foreign demand rises → export revenue increases → current account improves." Link points with connectives like "which leads to" and "therefore."

• Evaluate/discuss questions (8+ marks): Present both sides of the argument with developed chains of reasoning. Include conditions ("if demand is price elastic"), time periods ("in the short run... but in the long run"), and stakeholders ("benefits exporters but harms importers"). Conclude with a supported judgement referencing the context.

• Use data provided: If the question includes exchange rate figures, currency data, or economic indicators, incorporate them into your answer. Calculate percentage changes if relevant and reference specific numbers to support your points.

Quick revision summary

Exchange rates are determined by demand and supply in floating systems or set by governments in fixed systems. Appreciation/revaluation makes exports dearer and imports cheaper, typically worsening the trade balance but reducing inflation. Depreciation/devaluation makes exports cheaper and imports dearer, potentially improving the trade balance but causing inflation. The actual impact depends on price elasticity of demand (Marshall-Lerner condition) and time period (J-curve effect). Floating systems offer flexibility and automatic adjustment but create uncertainty; fixed systems provide stability but require reserves and remove policy independence. Exchange rate changes affect all macroeconomic objectives differently.