A LevelEconomicsAQARevision NotesThe National & International Economy14. The International EconomyFloating Exchange Rate Systems

Floating Exchange Rate Systems (AQA A Level Economics)

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Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Foreign Exchange Rates

  • An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18

    • International currencies are essentially products that can be bought & sold on the foreign exchange market (forex)
       

  • The Central Bank of a country controls the exchange rate system that is used in determining the value of a nation's currency
      

  • Two of the main exchange rate systems used are:

    • A floating exchange rate

    • A fixed exchange rate

1. A Floating Exchange Rate System

  • The forces of demand and supply determine the rate at which one currency exchanges for another and there is no government intervention in the currency market

  • Different currencies can be bought and sold, just like any other product

  • As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency appreciates)

  • If there is an excess supply of the currency on the forex market, then prices fall (the currency depreciates)

Diagram: Floating Exchange Rates

 

jKf4_p4T_6-3-1-1

The relationship between the US$ and the Euro shows that as Europeans demand the $ it appreciates but by supplying their own currency it depreciates

Diagram analysis

  • The Euro/US$ market is shown by two market diagrams - one for the USD market on the left and one for the Euro market on the right

  • The initial exchange rate equilibrium is found at P1Q1 in both markets

  • When Europeans visit the USA, they demand US$ and supply Euros

    • The increased demand for the US$ shifts the demand curve to the right which results in the value of the $ appreciating from P1 → P2 in the USD market and a new market equilibrium forms at P2Q2

    • The increased supply of the Euro shifts the supply curve to the right which results in the value of the Euro depreciating from P1 → P2  and a new market equilibrium forms at P2Q2

  

Floating exchange rate calculations

  • As the value of a currency appreciates or depreciates, the value of any international transaction changes

  • These changes can be significant for firms during times of exchange rate volatility

Worked Example

Marsha is a currency trader who buys and sells currency in order to make a profit. Currently, she is holding €200,000 and expects that the Pound will appreciate against the € in the next few months.

At present £1 = €1.10

  1. Marsha exchanges her Euros for Pounds. Calculate the quantity of Pounds she will receive for €200,000 [1]

  2. The Pound depreciates against the Euro by 10%. Fearing further depreciation, Marsha changes her Pounds back to Euros. Calculate the loss she has made. 

Step 1:  Calculate the quantity of Pounds received for €200,000

     begin mathsize 14px style fraction numerator 200 comma 000 over denominator 1.1 end fraction space equals £ 181 comma 818.18 end style
 

Step 2: Calculate the new exchange rate

    £1= (€1.10 x 0.9)  = €0.99 


Step 3: Use the above value to calculate the new amount of Euros

   £181,818.18 x 0.99 = £179,999,9982
 

Step 4: Round to two decimal places

      £180,000

 

Step 5: Calculate the loss

      £200,000 - £180,000 = £20,000 loss

Evaluating Exchange Rate Systems

  • Each exchange rate system has advantages and disadvantages attached

An Evaluation of A Floating Exchange Rate Mechanism

Advantages

Disadvantages

  • Natural fluctuations in the exchange rate based on demand and supply help to maintain stable current account balances

  • If a currency appreciates, the country's exports fall and imports rise

  • If a currency depreciates, the country's exports rise and imports fall

  • Fluctuations in the exchange rate can create uncertainty for firms, leading to a reduction in investment

    • E.g. if a firm provides a quotation to a foreign buyer based on today's exchange rate, but the exchange rate then appreciates, the domestic firm will not make as much profit as expected

  • Currency appreciation may allow costs of imported raw materials to decrease, which may help lower prices in the economy

  • Currency depreciation may cause costs of imported raw materials to increase, resulting in cost push inflation

  • Lower exchange rates (or a depreciating currency) may help to increase economic growth as export sales increase

  • Higher exchange rates (or an appreciating currency) may reduce/slow down economic growth as export sales decrease

  • Government does not need to monitor and maintain a fixed exchange rate

 

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    Author
    Reviewer
    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

    Jenna Quinn

    Author: Jenna Quinn

    Expertise: Head of New Subjects

    Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.