Exchange Rates (Edexcel IGCSE Economics): Revision Note

Foreign Exchange Rates

• An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18

  • International currencies are just like products that can be bought and sold on the global foreign exchange market (FOREX)

  • Increased demand for a currency in the FOREX market will increase its price or exchange rate, whereas increased supply of a currency to FOREX will decrease its price

• The Central Bank of a country will choose the exchange rate system that is used in determining the value of that nation's currency

  • Floating exchange rate systems allow the forces of demand and supply to determine the rate of exchange (price) of a currency

Graph analysis

• The graph shows the market for UK£ in terms of US$

• The market for UK pounds is in equilibrium, where D_£ = S_£ 

• Q UK pounds are received for a price of P dollars

• The equilibrium exchange rate is found at P₁Q₁

• There is no excess supply of pounds

• There is no excess demand for pounds

Factors Affecting the Demand for Currency

• Under a floating exchange rate system, a change in demand for a currency will affect the exchange rate

  • A rise in one exchange rate against another is an appreciation (or revaluation)

  • A fall in one exchange rate against another is a depreciation (or devaluation)

Relative interest rates set by the Central Bank

• These influence the flow of hot money between countries. If the UK's central bank increases its interest rate, then demand for £'s by foreign investors increases as they desire to move money into the UK to take advantage of those higher interest rates

Speculation

• The vast majority of currency trades are speculative. Speculation occurs when traders buy a currency in the expectation that it will be worth more in the short to medium term, at which point they will sell it to realise a profit

Demand for exports

• If the demand for exports of goods and services in the UK rises, foreign consumers will exchange their currency into UK £ to pay for these exports

• This increases the demand for the £ in the foreign exchange market

Factors Affecting Supply of Currency

Relative interest rates in foreign countries

• If the UK decreases its interest rate, then the supply of £s increases as investors sell their £s in favour of other currencies, and the £ depreciates

Speculation

• If there is an expectation that foreign currency will be worth more in the short to medium term, traders will supply their £s to demand the other currency

• This increases supply leading to a depreciation

Demand for imports

• If the demand for imports of goods and services into the UK rises, domestic consumers exchange their £ for foreign currencies to pay for these imports

• This increases the supply of £ in the foreign exchange market, which will cause the £ to depreciate