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

Foreign Exchange Rates (Forex)

• 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

1. A floating exchange rate system

• 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)

 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  

2. A fixed exchange rate system

• 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

Evaluating Exchange Rate Systems

• Each exchange rate system has advantages and disadvantages attached

An Evaluation of a Floating Exchange Rate Mechanism

An Evaluation of a Fixed Exchange Rate Mechanism