Foreign exchange rates | IGCSE Class 10 Economics Notes

This note covers the meaning of the foreign exchange rate, how demand and supply determine the equilibrium rate in the foreign exchange market, the main causes of exchange rate fluctuations, the consequences of these fluctuations for export and import prices and spending, and the differences, advantages and disadvantages of floating and fixed exchange rate systems.

What is a foreign exchange rate?

A foreign exchange rate is the price of one currency expressed in terms of another currency. It is also simply called the exchange rate. It links the currencies of different countries and allows people, firms and governments to compare the costs and prices of goods, services and assets across borders.

Definition: Foreign exchange rate. The price of one currency in terms of another currency; for example, if €50 must be paid for $1, the exchange rate is €50 per dollar.

The same idea applies to any pair of currencies. For instance, if 50 units of a home currency must be paid to obtain $1, the exchange rate is quoted as 50 per dollar.

Money must be used whenever goods, services or assets move across national borders, but there is no single world currency issued by one bank.

Each national currency is accepted abroad only if users are confident it will keep a reasonably stable purchasing power. The market in which national currencies are bought and sold for one another is called the foreign exchange market.

Its main participants are commercial banks, foreign exchange brokers, other authorised dealers and the monetary authorities of each country.

There are two broad systems by which a government or central bank can decide the exchange rate.

1. Under a floating exchange rate (also called a flexible exchange rate), the rate is left to be determined entirely by the market forces of demand and supply for the currency, and the central bank does not intervene.
2. Under a fixed exchange rate, the government or central bank sets the exchange rate at a particular level and then intervenes in the foreign exchange market, buying or selling its own currency, to keep the rate at that level.
3. Whichever system is used, the exchange rate still answers the same basic question: how much of the home currency must be given up to obtain one unit of a foreign currency.

How is the equilibrium foreign exchange rate determined?

In the foreign exchange market, the equilibrium rate under a floating system is found exactly as in any other market: it is the rate at which the quantity of foreign currency demanded equals the quantity of foreign currency supplied.

Demand for foreign exchange

People and firms demand foreign exchange because they want to buy goods and services from abroad (imports), because they want to send gifts abroad, and because they want to buy foreign financial assets.

A rise in the price of foreign exchange raises the cost, in home currency, of buying a foreign good. This reduces the quantity of imports demanded and so reduces the quantity of foreign exchange demanded, other things remaining constant. The demand curve for foreign exchange therefore slopes downward.

Supply of foreign exchange

Foreign currency flows into the home country because exports lead foreigners to buy the home country's goods and services, because foreigners send gifts or make transfers, and because foreigners buy the home country's financial assets.

A rise in the price of foreign exchange lowers the foreign buyer's cost, in their own currency, of buying home-country goods.

This tends to increase exports and so may increase the supply of foreign exchange, other things remaining constant, although whether it actually does so depends on factors such as the elasticity of demand for exports and imports.

On the vertical axis, plot the price of the foreign currency in units of the home currency (for example € per $); on the horizontal axis, plot the quantity of foreign currency bought and sold.

Draw a downward-sloping demand curve (D) and an upward-sloping supply curve (S) for the foreign currency. The point where D and S cross gives the equilibrium exchange rate (e*) and the equilibrium quantity (q*) of the foreign currency traded.

Definition: Equilibrium exchange rate. The exchange rate at which the quantity of a foreign currency demanded in the foreign exchange market exactly equals the quantity supplied.

If demand for a foreign currency rises while supply is unchanged, the demand curve shifts to the right and the equilibrium exchange rate rises: more home currency must now be paid for one unit of the foreign currency.

In a floating system this change in value of the currency is called depreciation (a fall in the value of the home currency against the foreign currency) or, from the other side, appreciation of the foreign currency.

Worked example 1. Suppose the home currency is € and the foreign currency is the dollar ($). At the original equilibrium, the exchange rate is €50 per dollar.

Demand for foreign goods and services then rises (for example because more people travel abroad), shifting the demand curve for dollars to the right. At the new equilibrium, the exchange rate becomes €70 per dollar.

Answer: Because more euros (€70 instead of €50) are now needed to buy one dollar, the price of the foreign currency in terms of the home currency has risen. This means the home currency (€) has depreciated against the dollar, and the dollar has appreciated against the euro.

What causes foreign exchange rate fluctuations?

Several factors shift the demand for, or supply of, a currency and so change the equilibrium exchange rate.

Changes in demand for exports and imports

If spending on imports rises (for example because of more foreign travel or more foreign goods being bought), the demand curve for foreign currency shifts to the right and the home currency tends to depreciate.

If demand for the country's exports rises (because foreign incomes rise, for example), the supply curve of foreign currency shifts outward, which tends to cause the home currency to appreciate.

If domestic demand grows faster than demand abroad, a country's imports normally grow faster than its exports, so its currency normally depreciates, because its demand curve for foreign currency shifts out faster than its supply curve.

Changes in the rate of interest

In the short run, differences in interest rates between countries, known as the interest rate differential, are an important cause of exchange rate movements.

Large funds held by banks, multinational corporations and wealthy individuals move around the world seeking the highest interest rates.

Investors sell the currency offering the lower return and buy the currency offering the higher return, shifting demand and supply curves and changing the exchange rate.

Worked example 2. Government bonds in Country A pay 8% interest, while equally safe bonds in Country B pay 10%.

Answer: The interest rate differential is 10% − 8% = 2 percentage points. Investors in Country A are attracted by the higher return in Country B, so they sell Country A's currency to buy Country B's currency.

At the same time, investors in Country B find it more attractive to keep their funds at home, so they demand less of Country A's currency.

The demand curve for Country A's currency shifts left and the supply curve shifts right, so Country A's currency depreciates and Country B's currency appreciates.

Speculation

Speculation occurs when people buy or hold a foreign currency purely because they expect its value to rise, hoping to make a gain.

This expectation itself can move the exchange rate, because speculative buying increases demand for the currency in the present, which can make the expected rise happen (the belief becomes self-fulfilling).

Worked example 3. The current exchange rate is €80 to the pound (£1). Investors believe the pound will appreciate by the end of the month to €85. An investor gives a dealer €80,000 and buys 1,000 pounds.

Answer: If the pound does rise to €85 by month end, the investor can exchange the 1,000 pounds for 1,000 × €85 = €85,000, a profit of €85,000 − €80,000 = €5,000.

Because many investors act on this belief and buy pounds now, demand for pounds rises immediately, pushing the euro-pound exchange rate up even before the month ends.

Entry and departure of multinational corporations (MNCs)

When a multinational corporation (MNC) enters a country, for example by setting up a new factory or buying local assets, it typically brings in foreign currency to pay for the investment, increasing the supply of foreign currency in that market and tending to cause the home currency to appreciate.

When MNCs withdraw investment and move funds out of a country, the opposite happens: foreign currency flows out, the supply of foreign currency available locally falls or demand for foreign currency to send abroad rises, and the home currency tends to depreciate.

What are the consequences of exchange rate fluctuations for export and import prices and spending?

A change in the exchange rate changes prices on both sides of trade.

• When the home currency depreciates (more home currency is needed per unit of foreign currency), home exports become cheaper in foreign currency and foreign imports become more expensive in home currency.
• When the home currency appreciates, exports become more expensive in foreign currency and imports become cheaper in home currency.

Whether total spending on exports and imports rises or falls depends on how responsive the quantity demanded is to the price change, that is, on the price elasticity of demand (PED) for exports and for imports.

A fall in the foreign-currency price of exports raises the quantity of exports sold; whether total export revenue (in foreign currency) rises depends on whether demand for exports is elastic or inelastic.

Likewise, a rise in the home-currency price of imports reduces the quantity bought; whether total import spending falls depends on the elasticity of demand for imports.

If demand for imports is price elastic (PED greater than 1), the quantity bought falls by a larger percentage than the price rises, so total spending on imports falls. If it is price inelastic (PED less than 1), the quantity falls by a smaller percentage than the price rises, so total spending on imports rises. Imports with few domestic substitutes, such as fuel, tend to have inelastic demand. An appreciation works the other way: import prices fall in the home currency, and spending on imports rises if demand is elastic and falls if it is inelastic.

Worked example 4. A good is exported at a fixed foreign-currency price of $10. The home currency depreciates, so exporters can now sell the same good for less foreign currency, say $8, while keeping their home-currency revenue similar.

The quantity sold rises from 100 units to 140 units because demand for exports is elastic.

Answer: Export revenue in foreign currency before depreciation = $10 × 100 = $1,000. After depreciation = $8 × 140 = $1,120. Because demand is elastic, the percentage rise in quantity sold (40%) is greater than the percentage fall in price (20%), so total export revenue in foreign currency rises.

Export revenue = Price × Quantity is the basic relationship behind this: a price fall raises revenue only if the resulting rise in quantity, governed by PED, is proportionately larger than the fall in price.

Floating and fixed exchange rates: differences, advantages and disadvantages

A floating exchange rate is set entirely by demand and supply in the market, with no central bank intervention. A fixed exchange rate is set by the government or central bank at a chosen level and defended by intervention.

How a fixed rate is defended

If the government fixes the exchange rate above the market rate (making the home currency cheaper for foreigners than the market would, in order to encourage exports), the supply of foreign currency at that rate exceeds demand; the central bank must step in to buy up the excess foreign currency, building up its official reserves.

If the government instead fixes the rate below the market level, demand for foreign currency exceeds supply at that rate, and the central bank must sell foreign currency from its reserves to meet the gap; if reserves run out, a black market for the foreign currency may develop.

Draw the usual downward-sloping demand curve and upward-sloping supply curve for a foreign currency, crossing at the market equilibrium rate e.

Mark a fixed rate e₁ set above e: at e₁, supply of the foreign currency exceeds demand, and the gap between the two curves at e₁ is the excess that the central bank must buy up to hold the rate there.

Under a fixed system, a government decision to lower the value of the home currency, by raising the officially fixed exchange rate, is called a devaluation. It makes the home currency cheaper.

A government decision to raise the value of the home currency, by lowering the officially fixed exchange rate, is called a revaluation. It makes the home currency more costly. These are deliberate policy changes, unlike depreciation and appreciation, which happen automatically through market forces under a floating system.

Advantages of a floating exchange rate

• Movements in the exchange rate automatically adjust to clear surpluses and deficits in a country's balance of payments, so large-scale intervention is not needed.
• The government does not need to hold large stocks of foreign exchange reserves, since it is not committed to defending a particular rate.
• Countries gain more independence in running their own monetary policy, because they are not forced to intervene simply to maintain a fixed rate.

Limitations of a floating exchange rate

• The exchange rate can move sharply and unpredictably in response to speculation or sudden shifts in interest rates, making planning for exporters and importers more difficult.
• Frequent and large depreciations can make imports persistently more expensive, adding to inflation.

Advantages of a fixed exchange rate

• It gives exporters, importers and investors greater certainty about future prices and costs, because the rate is officially maintained at a stated level.
• It can help keep inflation under control if it is tied credibly to a low-inflation currency, since import prices do not fluctuate with the market.

Limitations of a fixed exchange rate

• The system depends on the government having credibility that it can maintain the fixed rate; if reserves look inadequate, people may begin to doubt this.
• Doubt about the government's ability to defend the rate can lead to speculation of devaluation, and aggressive buying or selling of the currency can force an actual devaluation, known as a speculative attack on the currency.
• Defending the fixed rate uses up official reserves of foreign exchange, which are limited, and running out of reserves can lead to a black market in the currency.

Start with demand curve D and supply curve S for the foreign currency crossing at rate e₀.

Draw a new demand curve D′ to the right of D, representing a rise in demand for imports.

D′ crosses S at a higher rate e₁ than e₀, showing that the home currency has depreciated (more home currency is now needed to buy one unit of the foreign currency).

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it.

What is a managed floating exchange rate?

In practice, most countries today use neither a fully floating nor a fully fixed system, but a managed floating exchange rate, sometimes called dirty floating.

This is a mixture of the two systems: the exchange rate is mainly left to float with demand and supply (the float part), but the central bank still intervenes from time to time, buying or selling foreign currency, whenever it judges that the rate is moving too far or too fast (the managed part). Under this system, official reserve transactions are not equal to zero, unlike under a fully floating rate.

What is a speculative attack on a currency?

Fixed exchange rates are particularly vulnerable to a speculative attack, where aggressive buying or selling of a currency, driven by doubt about whether the government can defend the fixed rate, forces an actual devaluation. This kind of pressure was witnessed in the period before the collapse of the Bretton Woods system of fixed exchange rates.

What does the purchasing power theory predict?

Over the long run, some economists use the purchasing power theory to predict how exchange rates should move: as long as there are no barriers to trade such as tariffs or quotas, exchange rates should eventually adjust so that the same good costs the same amount whether measured in one currency or another, except for differences in transport costs.

Glossary

• Foreign exchange rate — the price of one currency in terms of another currency.
• Foreign exchange market — the worldwide market in which national currencies are bought and sold for one another.
• Floating exchange rate — an exchange rate determined entirely by market demand and supply, with no central bank intervention.
• Fixed exchange rate — an exchange rate set and defended by the government or central bank at a chosen level.
• Equilibrium exchange rate — the rate at which quantity of foreign currency demanded equals quantity supplied.
• Appreciation — a rise in the value of a currency relative to another currency under a floating system.
• Depreciation — a fall in the value of a currency relative to another currency under a floating system.
• Devaluation — a deliberate government decision to lower the value of the home currency under a fixed exchange rate system.
• Revaluation — a deliberate government decision to raise the value of the home currency under a fixed exchange rate system.
• Speculation — buying or holding a currency in the expectation of making a gain from a future rise in its value.
• Interest rate differential — the difference between interest rates offered on comparable assets in two countries.
• Multinational corporation (MNC) — a firm that owns or controls production of goods or services in more than one country.
• Price elasticity of demand (PED) — a measure of how responsive the quantity demanded of a good is to a change in its price.
• Official reserves — stocks of foreign currency and gold held by a central bank, used to defend a fixed exchange rate.

Common errors and misconceptions

• Misconception: Depreciation and devaluation mean the same thing. Correct: Depreciation is an automatic market fall in a floating currency's value; devaluation is a deliberate government decision to lower a fixed currency's officially set value.
• Misconception: A rising exchange rate (more home currency per unit of foreign currency) is always good news. Correct: A rise like this means the home currency has depreciated, which raises import prices even though it may help exporters.
• Misconception: A depreciation always increases total export revenue. Correct: Whether revenue rises depends on the price elasticity of demand for exports; if demand is inelastic, revenue can fall even though the quantity exported rises.
• Misconception: Interest rate changes affect only domestic borrowers. Correct: A rise in interest rates also attracts foreign funds seeking higher returns, which changes demand and supply of the currency and so the exchange rate.
• Misconception: Appreciation and revaluation are the same event. Correct: Appreciation is a market-driven rise in a floating currency's value; revaluation is a government decision under a fixed system.
• Misconception: A fixed exchange rate removes all risk of currency crisis. Correct: A fixed rate can be targeted by a speculative attack if traders doubt the government's reserves are enough to defend it.

Exam-style questions with model answers

Q1. Define the term "foreign exchange rate". [2 marks]

1. A foreign exchange rate is the price of one currency expressed in terms of another currency.
2. For example, if €50 must be paid to obtain one dollar, the exchange rate is €50 per dollar.

Q2. The exchange rate of the kip (LAK) fell from 1LAK = $0.0005 to 1LAK = $0.0004. Calculate the percentage fall in the value of the kip against the dollar. Show your working. [2 marks]

1. Fall in value = $0.0005 − $0.0004 = $0.0001.
2. Percentage fall = ($0.0001 ÷ $0.0005) × 100 = 20%.

Q3. Distinguish between appreciation and depreciation of a currency under a floating exchange rate system. [3 marks]

1. Depreciation occurs when a currency's value falls relative to another currency under a floating system, meaning more of the home currency is needed to buy one unit of the foreign currency.
2. Appreciation occurs when a currency's value rises relative to another currency under a floating system, meaning less of the home currency is needed to buy one unit of the foreign currency.
3. Both happen automatically through the market forces of demand and supply, with no government decision involved, unlike devaluation and revaluation under a fixed system.

Q4. Explain three causes of foreign exchange rate fluctuations. [6 marks]

1. A rise in demand for imports, for example due to more foreign travel, shifts the demand curve for foreign currency to the right, causing the home currency to depreciate.
2. A rise in the home country's interest rate relative to other countries creates an interest rate differential, attracting foreign investors who buy the home currency to earn the higher return, which causes the home currency to appreciate.
3. Speculation can also change the rate: if investors expect a currency to rise in value, they buy it now hoping to profit, and this extra buying itself pushes the exchange rate up before the expected rise even occurs.

Q5. Country A's government fixes its exchange rate above the market-determined rate in order to make its currency cheaper for foreign buyers. Analyse the problem this creates for the central bank. [6 marks]

1. At a fixed rate above the market rate, the supply of foreign currency offered to the central bank at that rate exceeds the demand for it, creating an excess supply.
2. To hold the rate at this level, the central bank must intervene by buying up the excess foreign currency with its own currency.
3. Doing this repeatedly causes the central bank's official reserves of foreign currency to keep growing.
4. If the government later wished to fix the rate below the market level instead, the problem would be the opposite: excess demand for foreign currency, which the central bank would have to meet by selling reserves.
5. If reserves ran low in that case, the government might be unable to maintain the fixed rate, and a black market in the foreign currency could develop.
6. Either way, defending a fixed rate commits the central bank to continuous intervention rather than letting the market find its own equilibrium.

Q6. A country's home currency depreciates. Explain, using the price elasticity of demand (PED), how this may affect the total revenue earned from its exports. [4 marks]

1. Depreciation makes a country's exports cheaper when priced in the foreign currency, which tends to increase the quantity of exports demanded by foreign buyers.
2. Whether total export revenue in foreign currency rises or falls depends on the price elasticity of demand (PED) for the exports.
3. If demand for the exports is elastic, the percentage rise in quantity sold is larger than the percentage fall in price, so total revenue rises.
4. If demand for the exports is inelastic, the percentage rise in quantity sold is smaller than the percentage fall in price, so total revenue falls even though more units are sold.

Q7. Distinguish between devaluation and depreciation of a currency. [3 marks]

1. Devaluation is a deliberate action by a government under a fixed exchange rate system, raising the officially set exchange rate to make the home currency cheaper.
2. Depreciation is an automatic market outcome under a floating exchange rate system, where the rate rises because demand for foreign currency exceeds supply, with no government decision involved.
3. Both result in the home currency buying less foreign currency than before, but one is a policy choice and the other is a market-driven change.

Q8. Discuss whether a government should adopt a fixed exchange rate rather than a floating exchange rate. [8 marks]

1. A fixed exchange rate gives exporters, importers and investors greater certainty about future costs and prices, since the rate is officially held steady, which can encourage trade and investment.
2. It can also help control inflation if the rate is tied credibly to a low-inflation currency, because import prices do not move with market swings in the exchange rate.
3. However, maintaining a fixed rate commits the central bank to continuous intervention, buying or selling foreign currency, and so requires it to hold large official reserves.
4. If markets doubt that the government's reserves are sufficient to defend the fixed rate, this can lead to speculation of devaluation and even a speculative attack that forces an actual devaluation.
5. A floating exchange rate, by contrast, adjusts automatically to clear surpluses and deficits in the balance of payments without needing large reserves, and gives the government more independence in running its own monetary policy.
6. The disadvantage of a floating rate is that it can move sharply due to speculation or interest rate changes, making planning harder for exporters and importers and potentially adding to inflation through unpredictable import price rises.
7. The better choice depends on a country's priorities: one most concerned with price stability and certainty for trade may prefer a fixed rate if it can credibly defend it, while one valuing monetary independence may prefer a floating rate.

Q9. Explain how the entry and departure of multinational corporations (MNCs) can cause a country's exchange rate to fluctuate. [4 marks]

1. When a multinational corporation enters a country, for example to build a new factory or buy local assets, it typically brings in foreign currency to pay for the investment.
2. This increases the supply of foreign currency in the local foreign exchange market, which tends to cause the home currency to appreciate.
3. When a multinational corporation departs and withdraws its investment, funds flow out of the country in foreign currency.
4. This reduces the supply of foreign currency available, or raises demand for foreign currency to be sent abroad, tending to cause the home currency to depreciate.

Key takeaways

• The foreign exchange rate is the price of one currency in terms of another, determined in the foreign exchange market.
• Under a floating rate, the equilibrium exchange rate is set where the demand for and supply of a currency are equal.
• A rise in demand for imports shifts the demand curve for foreign currency right, causing the home currency to depreciate.
• A rise in demand for exports shifts the supply curve of foreign currency outward, which tends to cause the home currency to appreciate.
• Interest rate differentials, speculation, and the entry or departure of multinational corporations can all shift demand or supply and change the exchange rate.
• Whether a depreciation raises or lowers total export or import spending depends on the price elasticity of demand for exports and imports.
• Under a fixed exchange rate, the government sets the rate and must intervene, using official reserves, to defend it.
• Devaluation and revaluation are deliberate government changes to a fixed rate; appreciation and depreciation are automatic market changes under a floating rate.
• Floating rates self-correct balance of payments gaps and need fewer reserves, but can be volatile; fixed rates give certainty but risk speculative attacks if reserves look inadequate.

Test yourself

What is a foreign exchange rate?

It is the price of one currency expressed in terms of another currency, for example €50 needed to buy $1.

What determines the equilibrium exchange rate under a floating system?

The point where the quantity of a foreign currency demanded equals the quantity supplied in the foreign exchange market.

Name three causes of exchange rate fluctuations.

Changes in demand for exports or imports, changes in interest rates, speculation, and the entry or departure of multinational corporations.

What is the difference between depreciation and devaluation?

Depreciation is an automatic market fall in a floating currency's value; devaluation is a deliberate government decision to raise a fixed exchange rate, making the currency cheaper.

Why does a fixed exchange rate require official reserves?

Because the central bank must buy or sell foreign currency to keep the rate at the fixed level whenever demand and supply do not match there.

What role does PED play in the consequences of a depreciation?

It determines whether the rise in export quantity outweighs the fall in export price, so whether total export revenue rises or falls.

Give one advantage and one disadvantage of a floating exchange rate.

Advantage: it automatically corrects balance of payments surpluses and deficits. Disadvantage: it can move sharply and unpredictably due to speculation.

Give one advantage and one disadvantage of a fixed exchange rate.

Advantage: it gives exporters and importers certainty about future prices. Disadvantage: defending it uses up official reserves and it can be forced down by a speculative attack.