Floating Exchange Rate Systems (AQA A Level Economics)

• 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 used are:
  • A floating exchange rate
  • A fixed exchange rate

• The forces of demand and supply determine the rate at which one currency exchanges for another and there is no government intervention in the currency market

• Different currencies can be bought and sold, just like any other product
• 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 excess supply of the currency on the forex market, then prices fall (the currency depreciates)

Diagram: Floating Exchange Rates

The relationship between the US$ and 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 and 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$ and 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 → P₂ in the USD market and 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 from P₁ → P₂  and a new market equilibrium forms at P₂Q₂

Floating exchange rate calculations

• As the value of a currency appreciates or depreciates, the value of any international transaction changes
• These changes can be significant for firms during times of exchange rate volatility

Step 1:  Calculate the quantity of Pounds received for €200,000

Step 2: Calculate the new exchange rate

    £1= (€1.10 x 0.9)  = €0.99 

Step 3: Use the above value to calculate the new amount of Euros

   £181,818.18 x 0.99 = £179,999,9982
 

Step 4: Round to two decimal places

      £180,000

 

Step 5: Calculate the loss

      £200,000 - £180,000 = £20,000 loss

• Each exchange rate system has advantages and disadvantages attached

An Evaluation of A Floating Exchange Rate Mechanism