Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas –Economics Revision Notes
Exchange Rates
The exchange rate is the rate at which one currency exchanges for another e.g. £1 = $2.
Exchange Rate Systems
Floating
The exchange rate is determined by market forces of supply and demand.
Fixed
This is when a country’s currency is fixed against a currency of another country. The most commonly used currency to fix against is the Dollar.
Managed
This exchange rate system is a floating exchange rate system but is subject to intervention by central banks.
Exchange Rate – Key Terms
Revaluation
This occurs when a country decides to increase the exchange rate of its currency under a fixed exchange rate
Appreciation
This refers to an increase in the value of a country’s exchange rate under a floating exchange rate.
Devaluation
This occurs when a country decides to decrease the exchange rate of its currency under a fixed exchange rate.
Depreciation
This refers to a decrease in the value of a country’s exchange rate under a floating exchange rate.
What factors influence exchange rates?
Interest Rates
If interest rates are high this will increase the demand for the pound causing the value of the pound to increase.
Inflation rates
If there is an increase in the inflation rate in the UK. This would make UK goods and services less competitive. This would cause a decrease in demand for the pound leading to a fall in the value of the currency.
Current Account Balance of Payments (BOP)
A persistent deficit on the BOP on the current account means there is excess supply over demand of the currency leading to a fall in the value of the pound.
Foreign Direct Investment (FDI)
If the UK has more inflows of FDI than outflows than it would be a net recipient. Therefore the demand for the UK pound would increase causing the value of the pound to rise.
Speculation/State of the economy
Speculation can occur due to a variety of factors such as the state of the economy. During the Coronavirus pandemic, the demand for the currency reduced as there was less confidence in the country.
Political factors
Political instability due to war, famine, corruption, Brexit can cause uncertainty and instability in a country. This will cause a decrease in demand and the value of the currency.
Government Intervention in Currency Markets
Interest Rates
The government can use interest rates to increase or decrease the demand for their currency
Higher Interest Rates– this will increase the demand for the Pound as it strengthens and more people will convert their money to pounds
Lower Interest Rates –this will reduce the demand for the Pound as it weakens and more people will keep their money in a different currency which offers more value for their money
Gold and Foreign Currency Reserves
Governments can use Gold and Foreign Currency Reserves to manipulate the value of their currency.
If value of the pound is too high– they can increase the supply of buying foreign currency or gold to weaken the value of the pound
If value of the pound is too low– they can increase the demand by selling their foreign currency or gold to strengthen the value of the pound
Competitive devaluation / depreciation
A country recognises the need to drive down the value of their currency and therefore intervenes in foreign exchange markets to create a competitive boost for their exporting industries
Weaker Currency– will encourage exports and discourage imports, improving the balance of payments. However, this may lead to inflation and reduce competitiveness
Impact of changes in exchange rates
Current Account of BOP
- The Marshall-Lerner condition– for a currency devaluation to have a positive impact on the trade balance, the sum of the elasticities of imports and exports must be elastic
- J Curve– this shows how the current account will worsen before it improves
- Rate of Inflation– imports become more expensive, causing prices to rise, if there is a fall in the exchange rate
- FDI– FDI may increase due to the cost of investing becoming cheaper, as a result of a fall in the currency
- Economic Growth and Unemployment– exports are likely to increase as they become cheaper due to a weaker exchange rate
AQA Spec – Additional Content
Advantages & Disadvantages of a Fixed and Floating Exchange Rate
Fixed Exchange Rate
Advantages:
- Allows firms to plan ahead in advance for investment opportunities, without worrying about harsh fluctuations in the exchange rate
- Provides a focused target that the Monetary Policy can work towards
Disadvantages:
- It may be the case that the government and the central bank do not know better than the market about where the currency should be
- The BOP does not adjust automatically to economic shocks
- If the government were to hold large reserves of foreign currencies, it can be costly
Floating Exchange Rate
Advantages:
- The exchange rate can adjust to economic shocks automatically
- More freedom for the Monetary Policy
Disadvantages:
- The fluctuations in the exchange rate can be unpredictable
- Can cause unemployment if there are drastic changes in the levels of exports / imports
- Exchange Rate can be vulnerable to speculative shocks
Advantages and Disadvantages for a country joining a currency union
In a monetary union, countries share the same currency – and example of this isThe Eurozone
When a monetary union is formed, a common central monetary policy is established
The same interest rate is also used amongst monetary unions
Advantages
- The members in the union have more currency stability and are at less risk to speculative shocks – future markets gain more certainty, so there is more investment and growth potential
- When travelling abroad or exchanging money, there are less admin fees / red tape
- It is also beneficial for firms which trade with countries of the same currency as it is cheaper and less time consuming
Disadvantages
- Language barriers create a limited labour mobility across countries in Europe
- A common monetary policy may not be effective due to the differences on economic performance between member countries
- It is difficult for the exchange rate to change in accommodation of each country’s needs
- When there is a common monetary union, member countries with stronger economies lose some of their sovereignty to member countries with weaker economies
- The one-off cost of joining a currency union can be expensive
Quick Fire Quiz – Knowledge Check
1. Define ‘Exchange Rate’ (2 marks)
2. Identify the three Exchange Rate Systems (3 marks)
3. Distinguish between a ‘Revaluation’ and ‘Devaluation’ (4 marks)
4. Distinguish between an ‘Appreciation’ and ‘Depreciation’ (4 marks)
5. Identify and explain six factors which influence exchange rates (12 marks)
6. Identify and explain two forms of government intervention in currency markets (6 marks)
7. Explain what is meant by a competitive devaluation / depreciation (4 marks)
8. Identify and explain fie impacts of changes in exchange rates (10 marks)
Next Revision Topics:
- Aggregate Demand
- Balance of Payments
- Globalisation
- Inflation
A Level Economics Past Papers
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