What is an exchange rate?
An exchange rate is the price of one currency in terms of another currency. It tells us how much of one currency is needed to buy another currency.
Example: if 1 US dollar = 0.80 British pounds, then a person who exchanges US$100 receives £80. If the exchange rate changes, the amount received also changes.
Simple idea
- A currency is bought and sold in the foreign exchange market.
- The price of a currency can rise or fall depending on demand and supply.
- Exchange rates affect the price of exports, imports, holidays abroad, foreign investment and inflation.
1. Determination of exchange rates in the foreign exchange market
In the foreign exchange market, people, firms, banks and governments buy and sell currencies. The exchange rate is affected by the demand for a currency and the supply of a currency.
Demand for a currency
Demand rises when foreigners want to buy a country’s exports, invest in the country, or save money in its banks.
Supply of a currency
Supply rises when people in the country buy imports, travel abroad, or invest money overseas.
Equilibrium exchange rate
The exchange rate is where demand for the currency equals supply of the currency.
Floating exchange rate system
A floating exchange rate is an exchange rate determined mainly by market forces of demand and supply. The government or central bank does not fix the rate at one level.
- Appreciation: when a currency rises in value under a floating exchange rate system.
- Depreciation: when a currency falls in value under a floating exchange rate system.
Example: if £1 rises from US$1.20 to US$1.30, the pound has appreciated. If £1 falls from US$1.30 to US$1.20, the pound has depreciated.
How to read the graph: the graph shows the demand for the currency rising from D₁ to D₂. This may happen if interest rates rise and foreign investors want to save or invest money in that country. The exchange rate rises from 0.55 to 0.65, so the currency has appreciated.
Fixed exchange rate system
A fixed exchange rate is an exchange rate set by the government or central bank. The central bank tries to keep the currency at a chosen value by buying or selling currencies from its foreign reserves.
- Revaluation: when the government raises the fixed value of the currency.
- Devaluation: when the government lowers the fixed value of the currency.
Example: if a government changes a fixed exchange rate from 7.80 units of its currency per US$1 to 7.50, the currency has been revalued. If it changes from 7.80 to 8.20, it has been devalued.
How to read the graph: the exchange rate is fixed at 7.8. Even if demand or supply changes, the authorities try to keep the rate at this level. To do this, the central bank may buy or sell its currency in the foreign exchange market.
2. Floating vs fixed exchange rates
| Point | Floating exchange rate | Fixed exchange rate |
|---|---|---|
| Who sets it? | Demand and supply in the market. | Government or central bank. |
| Currency rises | Called appreciation. | Called revaluation. |
| Currency falls | Called depreciation. | Called devaluation. |
| Main advantage | Adjusts automatically when market conditions change. | Gives firms more certainty when trading internationally. |
| Main problem | Can be unstable and change frequently. | Can be expensive to maintain using foreign reserves. |
3. Causes of exchange rate fluctuations
Exchange rates change when demand for a currency or supply of a currency changes.
Demand for exports
If foreigners buy more of a country’s exports, they need more of that country’s currency. Demand for the currency rises and the exchange rate may rise.
Demand for imports
If domestic consumers buy more imports, they supply more of their own currency to buy foreign currencies. This can lower the exchange rate.
Prices and inflation
High inflation makes exports more expensive and less competitive. Demand for the currency may fall, causing depreciation.
Foreign direct investment
If foreign firms invest in factories, offices or projects in a country, demand for that country’s currency may rise.
Exam chain
Higher interest rates → more foreign savings/investment → higher demand for the currency → appreciation.
Higher demand for imports → more domestic currency supplied → depreciation.
4. Consequences of exchange rate fluctuations
| Group / aim | If the currency appreciates | If the currency depreciates |
|---|---|---|
| Consumers | Imported goods and foreign holidays become cheaper. | Imported goods and foreign holidays become more expensive. |
| Exporters | Exports become more expensive for foreign buyers, so demand may fall. | Exports become cheaper for foreign buyers, so demand may rise. |
| Importers | Imported raw materials and finished goods become cheaper. | Imported raw materials and finished goods become more expensive. |
| Balance of payments | May worsen if exports fall and imports rise. | May improve if exports rise and imports fall, but this is not guaranteed. |
| Employment | Export industries may employ fewer workers if demand falls. | Export industries may employ more workers if demand rises. |
| Inflation | May reduce inflation because import prices fall. | May increase inflation because import prices rise. |
Important warning
The effects of exchange rate changes depend on how responsive consumers and firms are. For example, a depreciation may not improve the balance of payments immediately if foreign buyers do not increase demand for exports quickly.
5. Quick revision summary
- Exchange rate: the price of one currency in another currency.
- Floating system: demand and supply determine the rate.
- Fixed system: the government or central bank maintains the rate.
- Appreciation/revaluation: the currency rises in value.
- Depreciation/devaluation: the currency falls in value.
- Exchange rate changes affect consumers, exporters, importers, employment, inflation and the balance of payments.
Easy exam method
- State whether the currency has appreciated/depreciated or been revalued/devalued.
- Explain what caused the change, such as exports, imports, inflation, interest rates or FDI.
- Explain one effect on exports or imports.
- Link the effect to inflation, employment or the balance of payments.