Floating Exchange Rates (Cambridge (CIE) IGCSE Economics): Revision Note

Key exchange rate definitions

• A floating exchange rate is one that is determined by the forces of demand and supply in the foreign exchange market, without direct government or central bank control

• Appreciation occurs when the value of a currency rises compared to another currency in a floating system (e.g. £1 = $1.25 → £1 = $1.35)

• A depreciation occurs when the value of a currency falls compared to another currency in a floating system (e.g. £1 = $1.25 → £1 = $1.10)

Determination of the foreign exchange rate

• Different currencies can be bought and sold, just like any other product

• The equilibrium exchange rate is where the quantity of a currency demanded equals the quantity supplied

  • At this rate, the market is in balance — there is no shortage or surplus of the currency

  • If demand increases or supply decreases, the currency appreciates

  • If demand decreases or supply increases, the currency depreciates

Demand for a currency comes from:

• Foreigners buying the country’s exports

• Tourists visiting the country

• Foreign investors buying assets, shares or property

• Speculators who expect the currency to appreciate

The supply of a currency increases when:

• Citizens import more foreign goods and services

• Tourists travel abroad and need foreign currency

• Investors send money abroad

• Speculators sell the currency expecting it to fall in value

 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  

Causes of foreign exchange rate fluctuations

• Several factors cause exchange rates to change. Three of the most common include: