6.4 Exchange rates
- Syllabus
- 9708–2026–2027
- Topic
- 6.4
- Level
- AS
Learning objectives
6.4.1Exchange rate• Definition of exchange rate6.4.2Floating exchange rate• Determination of a floating exchange rate6.4.3Depreciation vs appreciation• Distinction between depreciation and appreciation of a floating exchange rate6.4.4Exchange rate changes• Causes of changes in a floating exchange rate: demand and supply of the currency6.4.5Exchange rates in AD/AS• AD/AS analysis of the impact of exchange rate changes on the domestic economy's equilibrium national income and the level of real output, the price level and employment
An exchange rate is one currency's price in another
An exchange rate is the price of one currency expressed in units of another. In £1 = US$1.30, sterling is the base currency and dollars are the quote currency: one pound buys 1.30 dollars.
State the quote before interpreting or converting. If £1 = €1.20 and €1 = US1.40,then£1=1.20×1.40=US1.68. Reverse a quote by taking its reciprocal.
| Rate | Meaning |
|---|---|
| Nominal exchange rate | Currency-for-currency market quotation in money terms |
| Real exchange rate | Nominal rate adjusted for relative price levels; indicates relative purchasing power/competitiveness |
A larger number means the base currency buys more quote currency only under the stated quotation. Do not call a currency stronger without naming the other currency and direction.
Currency demand and supply set a floating exchange rate
In a floating exchange-rate system, the market equilibrium exchange rate is set where demand for a currency equals its supply in the foreign-exchange market, rather than at a fixed official parity.
On a diagram, put the price/exchange rate of the named currency on the vertical axis and quantity traded on the horizontal axis. Downward-sloping demand and upward-sloping supply meet at the equilibrium rate; a shortage pushes the rate up and a surplus pushes it down.
| Floating rate | Fixed rate |
|---|---|
| Market demand and supply determine the rate | Government/central bank targets an official rate |
| Can adjust automatically but may fluctuate and create uncertainty | Offers predictability but may require reserves, interest changes or controls |
| Leaves more monetary-policy independence | Policy may be constrained by defending the rate |
Floating does not mean random or untouched by policy. Interest decisions, reserve intervention and controls can shift demand or supply even when no official parity is fixed; the causes belong to the later objective.
Appreciation and depreciation are opposite floating-rate movements
| Movement of the named floating currency | Quote example (£1 = US$...) | First-round price effect |
|---|---|---|
| Appreciation: value rises | 1.20 → 1.30 | Foreign goods/imports cheaper in pounds; UK exports dearer in dollars |
| Depreciation: value falls | 1.20 → 1.10 | Imports dearer in pounds; UK exports cheaper in dollars |
For an inverted quote such as ringgit per US dollar, a rise from RM3.1 to RM4.2 per dollar means the dollar appreciates and the ringgit depreciates: more ringgit are needed to buy one dollar.
| Market system | Rise | Fall |
|---|---|---|
| Floating rate | Appreciation | Depreciation |
| Fixed/managed official change | Revaluation | Devaluation |
These terms describe a bilateral value change, not a guaranteed current-account result. Quantities, elasticities, contracts and time determine the later trade response.
Trace every exchange-rate cause through currency demand or supply
Use four links: economic change → reason people need or sell the currency → demand or supply curve shift → appreciation or depreciation at the new floating-market equilibrium.
| Change | Currency-market shift | Likely rate movement |
|---|---|---|
| Export demand, tourism receipts or inward investment rises | Demand right | Appreciation |
| Imports or outward investment rises | Supply right | Depreciation |
| Domestic interest/expected asset return rises relative to abroad | Demand right and/or supply left | Appreciation, if confidence and other returns support inflow |
| Domestic interest return falls | Demand left and/or supply right | Depreciation |
| Domestic inflation rises relative to partners | Export demand/currency demand falls; import demand/currency supply rises | Depreciation |
| Confidence falls or speculators expect a fall | Demand left and/or supply right | Depreciation |
| Central bank sells foreign reserves and buys domestic currency | Demand right | Supports appreciation / resists depreciation |
Most causes are relative. A domestic rate rise has no certain effect if foreign rates rise similarly; higher overseas income may increase demand for domestic exports and appreciate the currency; foreign trade barriers can reduce export demand and depreciate it.
Do not jump from inflation, imports or interest rates straight to the exchange rate. Name who buys or sells which currency and the curve that moves. This objective explains causes, not the later AD/AS consequences.
Use AD/AS to analyse both currency movements
Trace the rate change through two channels: export/import prices change net exports and AD; imported raw-material and component prices can change production costs and SRAS. Then read equilibrium national income/real output, price level and employment.
| Movement | AD channel | SRAS/cost channel | Likely equilibrium effects |
|---|---|---|---|
| Depreciation | Exports cheaper abroad, imports dearer at home; if net exports rise, AD shifts right | Imported inputs dearer; SRAS may shift left | Output/employment may rise through AD but be limited by costs; price level tends to rise through demand-pull and/or cost-push pressure |
| Appreciation | Exports dearer abroad, imports cheaper at home; if net exports fall, AD shifts left | Imported inputs cheaper; SRAS may shift right | Output/employment may fall through AD, while lower costs offset some loss; price/inflation pressure tends to fall |
Depreciation tends to help exporters using domestic inputs and import-competing firms, but hurts consumers, importers and producers reliant on foreign inputs. Appreciation broadly reverses these groups: consumers and input importers gain purchasing power while exporters face weaker price competitiveness.
Magnitude depends on export/import demand elasticities, spare capacity, import content of production, ability of domestic supply to expand, contracts and time, confidence, foreign-currency debt and the size/persistence of the rate change.
A rate movement is not automatically an AD shift: explain the net-export response. Depreciation can fail to raise output when imports are essential or supply is constrained; appreciation does not guarantee lower unemployment or a better current account.