In simple terms
A friendly intro before the formal notes — no formulas yet.
Exchange rates
9708 AS exchange rates — floating and fixed systems, appreciation, depreciation, and effects on trade with GeoGebra.
- 1
A floating exchange rate is determined by market forces of demand and supply.
- 2
Demand for a currency is derived from the demand for a country's exports, services, and assets.
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Supply of a currency arises from domestic residents' demand for foreign goods, services, and assets.
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The equilibrium exchange rate is found at the intersection of the demand and supply curves.
Explore the concept
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Exchange rate: price of one currency in another (e
Exchange rate: price of one currency in another (e.g. £/
At a glance — side by side
Compare key properties side by side — ideal for exam contrasts.
Comparing Floating and Fixed Exchange Rate Systems
| Feature | Floating System | Fixed System |
|---|---|---|
| Determination | Determined by market forces of demand and supply. | Set by the government/central bank at a specific 'peg'. |
| Certainty & Stability | Can be volatile and uncertain, creating risk for traders and investors. | Provides stability and certainty, which encourages trade and investment. |
| Policy Autonomy | Monetary policy (e.g., interest rates) can be used to meet domestic objectives like inflation or unemployment. | Monetary policy must often be used to defend the peg, limiting its use for domestic objectives. |
| Balance of Payments Adjustment | Adjusts automatically. A current account deficit leads to depreciation, which should self-correct the deficit. | Imbalances can persist. A large deficit may require a deliberate, and often disruptive, devaluation. |
| Required Reserves | No need for large foreign currency reserves for intervention. | Requires large holdings of foreign currency reserves to defend the peg against market pressures. |
Determination
Floating System
Fixed System
Certainty & Stability
Floating System
Fixed System
Policy Autonomy
Floating System
Fixed System
Balance of Payments Adjustment
Floating System
Fixed System
Required Reserves
Floating System
Fixed System
Full topic notes
Formal explanation with the rigour you need for the exam.
The Determination of Floating Exchange Rates
A floating exchange rate is determined by the uninhibited interaction of the forces of demand and supply for a currency on the foreign exchange market (FOREX). The demand for a currency, for instance the pound sterling (£), is a derived demand; it comes from foreign individuals, firms, and governments who need pounds to buy UK exports, invest in the UK (FDI), or save in UK banks (attracted by interest rates). This demand curve is downward sloping. The supply of pounds comes from UK residents wishing to exchange their pounds for foreign currency to buy imports, invest abroad, or go on holiday. The supply curve is upward sloping. The equilibrium exchange rate is established where the quantity demanded equals the quantity supplied. A GeoGebra diagram would show price (£ per $) on the y-axis and quantity of currency on the x-axis, with intersecting demand and supply curves.
A floating exchange rate is determined by market forces of demand and supply.
Demand for a currency is derived from the demand for a country's exports, services, and assets.
Supply of a currency arises from domestic residents' demand for foreign goods, services, and assets.
The equilibrium exchange rate is found at the intersection of the demand and supply curves.
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.
Factors Causing Exchange Rate Fluctuations
In a floating system, several factors can shift the demand and supply curves, causing the exchange rate to appreciate or depreciate. A key factor is relative interest rates. If the UK raises its interest rates relative to the US, it attracts 'hot money' flows as investors seek higher returns. This increases the demand for pounds, shifting the demand curve to the right and causing the pound to appreciate. Conversely, a fall in UK interest rates would likely cause depreciation. Other factors include relative inflation rates (lower inflation boosts competitiveness and demand for the currency), changes in national income (rising income increases demand for imports, increasing supply of the currency), speculation, and long-term foreign direct investment (FDI).
Higher relative interest rates attract 'hot money', increasing demand and causing appreciation.
Lower relative inflation makes exports more competitive, increasing demand and causing appreciation.
Strong economic growth can increase import spending, increasing currency supply and causing depreciation.
Speculators' expectations can become a self-fulfilling prophecy, causing significant volatility.
Fixed Exchange Rate Systems and Central Bank Intervention
A fixed exchange rate system is where a government or central bank sets and maintains an official exchange rate, or 'peg', against another currency or a basket of currencies. This provides certainty for international trade and investment. However, the fixed rate may not be the market equilibrium rate. If the market value is tending to fall below the peg, the central bank must intervene. It can do this by buying its own currency using its foreign currency reserves, which increases demand and supports the price. Alternatively, it can raise interest rates to attract capital inflows. If the peg is officially lowered, it is called a 'devaluation'. If it is officially raised, it is a 'revaluation'.
The value is set by official government policy, not market forces.
Central banks must intervene to maintain the pegged rate.
Intervention methods include using foreign reserves and changing domestic interest rates.
Devaluation and revaluation are official policy acts, distinct from depreciation and appreciation.
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.
The Economic Consequences of Exchange Rate Changes
Changes in the exchange rate have widespread macroeconomic consequences. A depreciation (or devaluation) makes exports cheaper in foreign currency and imports more expensive in the domestic currency. This can improve the current account balance by boosting export revenue and reducing import expenditure, provided the Marshall-Lerner condition holds. The resulting increase in net exports (X-M) boosts aggregate demand, potentially leading to economic growth and lower unemployment. However, it can also cause inflation, both demand-pull (from higher AD) and cost-push (from more expensive imported raw materials). An appreciation (or revaluation) has the opposite effects: it can worsen the current account and dampen AD, but helps to control inflation by making imports cheaper.
Depreciation/Devaluation: Exports cheaper, imports dearer. Can improve current account, boost AD and growth, but may cause inflation.
Appreciation/Revaluation: Exports dearer, imports cheaper. Can worsen current account, dampen AD, but helps reduce inflation.
The impact on the current account depends on the price elasticity of demand for exports and imports (Marshall-Lerner condition).
The J-Curve effect describes how the current account may worsen initially after a depreciation before improving in the long run.
Floating exchange rates
Under a floating system, the exchange rate is determined by supply and demand in the foreign exchange (forex) market.
Demand for £ comes from foreigners buying UK exports, UK assets, or visiting the UK.
Supply of £ comes from UK residents buying imports, foreign assets, or travelling abroad.
Equilibrium sets the market exchange rate without day-to-day government intervention.
Appreciation — demand for £ rises or supply falls → £ buys more foreign currency.
Depreciation — supply of £ rises or demand falls → £ buys less foreign currency.
Higher UK interest rates can attract hot money → demand for £ rises → appreciation.
Higher inflation relative to trading partners can weaken competitiveness → depreciation pressure.
Effects on trade and AD
A depreciation makes UK exports cheaper in foreign currency and imports dearer in sterling. If demand is price elastic, net exports rise and AD increases.
An appreciation has the opposite effect: exports dearer, imports cheaper → net exports may fall → AD decreases.
Always trace the chain: exchange rate → price of X and M → (X − M) → AD.
Fixed and managed rates
Under a fixed (or managed) system, the central bank targets an exchange rate band. If market pressure pushes the rate away from the peg, the bank intervenes by buying or selling foreign currency reserves.
To prevent depreciation: buy £ with foreign reserves (reduces supply of £). To prevent appreciation: sell £ and buy foreign currency (increases supply of £).
Reserves are finite — fixed rates can be difficult to sustain if fundamentals (inflation, competitiveness) diverge from the peg.
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.
Worked examples
See the formulas applied — reveal one step at a time, like the exam.
The sterling–dollar exchange rate falls from £1 = 1.20. A UK car costs £20 000 to produce and is sold in the US.
(a) Calculate the dollar price before and after depreciation. (b) Explain the likely effect on UK car exports and aggregate demand.
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(a) Before: 28 000** After: 24 000**
A UK company imports a machine from Germany priced at €50,000. Initially, the exchange rate is £1 = €1.15. The pound then appreciates against the euro to a new rate of £1 = €1.25.
(a) Calculate the cost of the machine in pounds sterling (£) before the appreciation. (b) Calculate the cost of the machine in pounds sterling (£) after the appreciation. (c) Explain one likely effect on the UK economy.
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(a) Before appreciation: To find the cost in pounds, we divide the euro price by the exchange rate (€ per £). Cost in £ = Price in € / Exchange Rate Cost in £ = €50,000 / 1.15 = £43,478.26
How it all connects
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Glossary
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Quick check
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Revision flashcards
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What is an exchange rate?
The price of one currency expressed in terms of another (e.g. £1 =
Key takeaways
Review these before you close the topic — retrieval beats re-reading.
- ✓
A floating exchange rate is determined by market forces of demand and supply.
- ✓
Demand for a currency is derived from the demand for a country's exports, services, and assets.
- ✓
Supply of a currency arises from domestic residents' demand for foreign goods, services, and assets.
- ✓
The equilibrium exchange rate is found at the intersection of the demand and supply curves.
Practice — then mark it
The whole point: a real Cambridge question, marked mark-by-mark.
9708/21 · Q1(c)
Consider the extent to which depreciation of the Sri Lankan rupee could improve the country's balance of trade in goods and services.
9708/22 · Q1(c)
Consider whether continued falls in the value of the South African rand may lead to a reduction in the current account deficit of the balance of payments.
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