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Cambridge (CIE) O Level Your notes

Economics
6.3 Foreign Exchange Rates
Contents
Introduction to Exchange Rates
Exchange Rate Fluctuations

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Introduction to Exchange Rates

Your notes
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)

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Your notes

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

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

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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 Your notes
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

Advantages Disadvantages

Natural fluctuations in the Fluctuations in the exchange rate can create uncertainty for
exchange rate based on firms, leading to a reduction in investment e.g. if a firm
demand and supply help to provides a quotation to a foreign buyer based on today's
maintain stable current exchange rate, but the exchange rate then appreciates, the
account balances domestic firm will not make as much profit as expected
If a currency appreciates, the
country's exports fall and
imports rise
If a currency depreciates, the
country's exports rise and
imports fall

Currency appreciation may Currency depreciation may cause costs of imported raw
allow costs of imported raw materials to increase resulting in cost push inflation
materials to decrease which
may help lower prices in the
economy

Lower exchange rates (or a Higher exchange rates (or an appreciating currency) may
depreciating currency) may reduce/slow down economic growth as export sales

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help to increase economic decrease

growth as export sales increase
Your notes
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 In order to maintain the fixed exchange rate, the
country's exports, the price of its exports Central Bank has to regularly intervene in the
will remain fixed as the currency will not currency market by buying or selling its own
appreciate with more demand currency
This can boost export sales over time e.g. This can be an expensive policy to maintain
China did this for many years and its
products remained artificially cheap to buy

Firms (foreign and domestic) benefit as they Changing the interest rate can also influence the
can agree prices with a high level of exchange rate
certainty as the exchange rate will not
fluctuate Changing the interest rate to maintain a fixed
exchange rate can have negative consequences
on consumption, investment, lending, saving
and borrowing

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Exchange Rate Fluctuations

Your notes
Causes of Exchange Rate Fluctuations
Numerous factors influence floating exchange rates, resulting in an appreciation or depreciation of a
currency

Factors influencing floating exchange rates

1. Relative interest rates: influence the flow of hot money between countries. If the UK increases its
interest rate, then demand for £'s by foreign investors increases and the £ appreciates. If the UK
decreases its interest rate, then the supply of £'s increases as investors sell their £'s in favour of other
currencies and the £ depreciates
2. Relative inflation rates: as inflation in the UK rises relative to other countries, its exports become more
expensive so there is less demand for UK products by foreigners, which means there is less demand for
£s and so the £ depreciates
3. Net investment: foreign direct investment (FDI) into the UK creates a demand for the £ which leads to
the £ appreciating. FDI by UK firms abroad creates a supply of £'s which leads to the £ depreciating
4. The current account: UK exports have to be paid for in £'s. UK imports have to be paid for in local
currencies, which requires £'s to be supplied to the forex market. Due to this, an increasing net exports

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will result in an appreciation of the £ and falling net exports will result in a depreciation of the £
5. Changes in tastes/preferences: As global demand for quinoa increased as it became fashionable,
Bolivia's exports of quinoa increased dramatically which put upward pressure on their currency. Your notes
Foreigners demanded the Boliviano in order to pay for the quinoa
6. Speculation: the vast majority of currency trades are speculative. Speculation occurs when traders
buy a currency in the expectation that it will be worth more in the short to medium term, at which point
they will sell it to realise a profit
7. Quantitative easing: involves increasing the money supply and much of the new supply is used to buy
back gilts. Many of these gilts are owned by foreigners who then exchange the £s received for their
own currency. The increase in the supply of £'s depreciates the £
8. MNCs: An increase in the number of MNCs globally will result in more money flows between countries,
each of which influences exchange rates
Consequences of Foreign Exchange Rate Fluctuations
Changes to exchange rates may have far-reaching impacts on an economy

The impact of changes to exchange rates on an economy

Economic Indicator Explanation

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The Current From a UK perspective, the depreciation of the £ causes exports to be

Account cheaper for foreigners to buy and imports to the UK are more expensive
Your notes
The extent to which a currency depreciation improves the current account
balance depends on the price elasticity of demand for exports and imports
This follows the revenue rule which states that in order to increase
revenue, firms should lower prices for products that are price elastic in
demand
If the price elasticity of demand for UK exports is elastic, then a
depreciation of the currency will result in a larger than proportional
increase in demand for UK exports, which will rapidly improve any current
account deficit

Economic growth Net exports are a component of total (aggregate) demand

A depreciation that results in an increase in net exports will lead to
economic growth

Inflation Cost push inflation can be caused by a depreciating currency as the price of
imported raw materials increases with a weaker currency
Net exports are a component of total (aggregate) demand
A depreciation that results in an increase in net exports will lead to an
increase in total demand
This may lead to an increase in demand pull inflation
An appreciation of the currency will have the opposite effect

Unemployment If depreciation leads to an increase in exports, unemployment is likely to fall

as more workers are required to produce the additional products demanded
An appreciation of the currency will have the opposite effect

Living standards The impact of a depreciation on living standards can be muted

As imports are more expensive, households face higher prices and less
choice, which detracts from living standards

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Rising exports can decrease unemployment and increase

wages/income which means an improved standard of living for some
households Your notes
The impact of an appreciation on living standards will be the opposite

Foreign direct Depreciation of a currency makes it cheaper for foreign firms to invest in the
investment (FDI) country which can increase investment and real GDP
An appreciation has the opposite effect

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