Exchange rates — common mistakes

Always draw and label your foreign exchange market diagrams accurately. Label the vertical axis as 'Price of Currency A in terms of Currency B' (e.g., $/£) and the horizontal axis as 'Quantity of Currency A'. When explaining a change, state which curve shifts, why it shifts, and the resulting appreciation or depreciation.

When analysing a fixed system, a key evaluation point is the potential conflict between exchange rate policy and domestic policy. For example, a central bank might have to raise interest rates to defend the peg, even if the domestic economy is in a recession and needs lower interest rates.

In exam answers, draw a forex market (S and D for £) when explaining appreciation/depreciation. Label axes (exchange rate, quantity of £) and show the shift. Link to (X − M) in a separate AD diagram for full marks.

Not necessarily. While a strong currency (appreciation) makes imports cheaper for consumers and firms, reducing cost-push inflation, it also makes exports more expensive for foreigners. This can harm export-oriented industries, reduce international competitiveness, worsen the current account deficit, and potentially lead to job losses in those sectors. The 'best' level for a currency depends on a country's specific economic objectives at the time.

The key difference lies in the exchange rate system. 'Depreciation' is a fall in a currency's value due to market forces of supply and demand in a floating system. 'Devaluation' is a fall in a currency's value as a result of a deliberate policy decision by the government or central bank in a fixed exchange rate system. The terms are not interchangeable and using them correctly demonstrates precise economic knowledge.

Not automatically. The improvement depends on the Marshall-Lerner condition (PEDx + PEDm > 1). If the demand for both exports and imports is price inelastic, a depreciation will worsen the trade balance, as the increased cost of imports outweighs the revenue gain from slightly more exports. In the short run, demand is often inelastic, leading to an initial worsening of the trade balance before it improves as consumers and firms adjust. This phenomenon is known as the J-Curve effect.