2.2.3 Exchange rates
- Syllabus
- 2026
- Topic
- 2.2.3
- Level
- —
Learning objectives
2.2.3a Exchange ratesDefinition of exchange rates.2.2.3b Factors affecting supply and demand of currenciesFactors affecting supply and demand of currencies:• interest rates• currency speculators• imports and exports of goods and services• supply and demand diagrams to show determination of exchange rates.2.2.3c AppreciationDefinition of appreciation:• definition of revaluation• impact of appreciation of exchange rate on:- import and export prices- demand for imports and exports- current account on balance of payments.2.2.3d DepreciationDefinition of depreciation:• definition of devaluation• impact of depreciation of exchange rate on:- import and export prices- demand for imports and exports- current account on balance of payments.
Read and calculate an exchange rate
An exchange rate is the price of one currency expressed in another currency.
| Quotation | Meaning | Conversion |
|---|---|---|
| £1 = €1.10 | one pound buys 1.10 euros | pounds → euros: multiply by 1.10 |
| £1 = €1.10 | 1.10 euros buys one pound | euros → pounds: divide by 1.10 |
Identify the currency you have and the currency required, write the units beside the rate, choose multiplication or division so the starting unit cancels, then include the destination currency and sensible rounding.
Example: £15,000 × €1.10 per £ = €16,500. Reverse check: €16,500 ÷ 1.10 = £15,000.
A larger number in a quotation such as £1 = $x means the pound buys more dollars; it does not mean every currency in the pair has strengthened.
Determine exchange rates from currency supply and demand
In a floating system, the exchange rate is determined where demand for a currency equals its supply. The vertical axis is the price of that currency in another currency; the horizontal axis is its quantity.
| Change for the domestic currency | Curve shift | Exchange-rate result |
|---|---|---|
| domestic interest rates rise relative to abroad | foreign savers/investors demand more domestic currency → D right | appreciation |
| speculators expect the currency to rise | they buy it now → D right | appreciation |
| exports increase | foreign buyers need domestic currency → D right | appreciation |
| imports increase | domestic buyers sell domestic currency for foreign currency → S right | depreciation |
| imports decrease | less domestic currency is sold → S left | appreciation |
For a diagram answer: name the currency priced on the vertical axis, shift only the causal curve, label D1 or S1, and mark the new exchange rate and quantity. D right or S left raises the currency's price; D left or S right lowers it.
Interest rates and speculation affect capital flows, while exports and imports affect trade-related currency flows. The final movement depends on the net size of all simultaneous demand and supply changes.
An increase in domestic imports shifts supply of the domestic currency, not demand: residents must exchange it to obtain foreign currency for payment.
Trace an appreciation through prices, trade and the current account
Appreciation is a rise in a currency's value caused by market forces in a floating exchange-rate system. Revaluation is an official upward change in its value in a fixed or managed system.
| Channel after appreciation | Price effect | Likely demand effect | Current-account pressure |
|---|---|---|---|
| exports | domestic exports become more expensive to foreign buyers | export demand falls | export revenue tends to fall |
| imports | foreign goods become cheaper to domestic buyers | import demand rises | import expenditure tends to rise |
Both channels tend to worsen the current account balance: lower export receipts and higher import spending can reduce a surplus or enlarge a deficit.
The size and timing depend on price elasticity of demand, the scale and duration of appreciation, contracts, quality and non-price competitiveness. Inelastic export demand or cheaper imported inputs can weaken or partly offset the predicted effect.
Appreciation and revaluation both raise currency value, but the cause/system differs. Do not use the terms as exact synonyms.
Trace a depreciation through prices, trade and the current account
Depreciation is a fall in a currency's value caused by market forces in a floating exchange-rate system. Devaluation is an official downward change in its value in a fixed or managed system.
| Channel after depreciation | Price effect | Likely demand effect | Current-account pressure |
|---|---|---|---|
| exports | domestic exports become cheaper to foreign buyers | export demand rises | export revenue tends to rise |
| imports | foreign goods become more expensive to domestic buyers | import demand falls | import expenditure tends to fall |
Both quantity responses tend to improve the current account balance: stronger exports and weaker imports can enlarge a surplus or reduce a deficit.
Improvement is not automatic. It depends on demand elasticities, size and duration, contracts, spare capacity, quality and how much production relies on imported inputs. A higher import price can initially raise spending before quantities adjust.
Depreciation is not the same as inflation and does not guarantee higher exports. It changes relative prices; buyers must respond and domestic firms must be able to supply.