Introduction to Exchange Rates (Cambridge (CIE) O Level Economics)

Revision Note

Written by: Steve Vorster

Reviewed by: Jenna Quinn

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 and 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 are
- A floating exchange rate
- A fixed exchange rate

Different currencies can be bought and sold, just like any other product
The forces of demand and supply determine the rate at which one currency exchanges for another
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)

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 → P₂in 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 → P₂and a new market equilibrium forms at P₂Q₂

A system in which the country’s Central Bank intervenes in the currency market to fix (peg) the exchange rate in relation to another currency e.g US$
- When they want their currency to appreciate, they buy it on forex markets using their foreign reserves, thus increasing its demand
- When they want their currency to depreciate, they sell it on forex markets, thus increasing its supply
Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar
Often the peg is not at parity e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1
A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency
A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency

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

An Evaluation of a Fixed Exchange Rate Mechanism

Advantages	Disadvantages
Even with an increasing demand for a country's exports, the price of its exports will remain fixed as the currency will not appreciate with more demand This can boost export sales over time e.g. China did this for many years and its products remained artificially cheap to buy	In order to maintain the fixed exchange rate, the Central Bank has to regularly intervene in the currency market by buying or selling its own currency This can be an expensive policy to maintain
Firms (foreign and domestic) benefit as they can agree prices with a high level of certainty as the exchange rate will not fluctuate	Changing the interest rate can also influence the exchange rate Changing the interest rate to maintain a fixed exchange rate can have negative consequences on consumption, investment, lending, saving and borrowing

Last updated: 27 June 2024

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