6.3.1 Introduction to Exchange Rates | CIE IGCSE Economics Revision Notes 2020 (2024)

• 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 & 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 & sold, just like any other product
• The forces of demand & 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 excesssupply of the currency on the forex market, then prices fall (the currency depreciates)

The relationship between the US$ & 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 & 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$ & 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 → P₂in the USD market & 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 fromP₁ → P₂ & 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 & increase the strength of its currency
• A devaluation occurs if the Central Bank decides to change the peg & decrease the strength of its currency

• Each exchange rate system has advantages & disadvantages attached

An Evaluation of A Floating Exchange Rate Mechanism

An Evaluation of A Fixed Exchange Rate Mechanism