Exchange Rate Systems and the Determination of Floating Rates
An exchange rate is the price of one currency expressed in terms of another, such as the number of US dollars a pound will buy.
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Method
- Define the exchange rate as the price of one currency in terms of another, and identify which system applies in the question: freely floating, managed float, or fixed.
- For a floating rate, set up a demand and supply diagram for the currency, with the exchange rate (e.g. pounds per dollar, or the number of dollars per pound) on the vertical axis and the quantity of the currency traded on the horizontal axis.
- Identify what shifts demand for the currency: higher relative UK interest rates attracting hot money inflows, rising UK exports, more inward foreign direct investment, or positive speculation about the pound.
- Identify what shifts supply of the currency: a UK interest rate cut, rising UK imports, more outward investment by UK residents or firms, or negative speculation about the pound.
- Draw the relevant shift and read off the new equilibrium: an increase in demand for, or a fall in supply of, a currency causes an appreciation; the reverse causes a depreciation.
- Evaluate using: the size of the interest rate or growth differential driving the shift, the state of speculative sentiment (currencies can move sharply on expectations even without a change in underlying fundamentals), and the assumption of ceteris paribus, since several factors often move at once, making the net effect on the exchange rate hard to predict with certainty.
Worked example
The GBP/USD exchange rate moves from 1.30 to 1.25 (that is, one pound buys fewer US dollars than before). Calculate the percentage change in the value of sterling against the dollar, and give two possible causes of this movement using the demand and supply framework.
- Calculate the change: 1.25 - 1.30 = -0.05.
- Calculate the percentage change: -0.05 / 1.30 x 100 = -3.85%.
- State the answer: sterling has depreciated by approximately 3.8% against the US dollar.
- Give a demand-side cause: a cut in UK interest rates relative to US interest rates could reduce inflows of hot money seeking a return in sterling, lowering demand for the pound.
- Give a supply-side cause: a widening UK current account deficit, meaning UK imports are rising faster than exports, raises the supply of sterling being sold to buy foreign goods, pushing the exchange rate down.
Practice questions
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Q1Define 'appreciation' of a currency.Show answer
Answer: A rise in the value of a currency against another currency (or a basket of currencies) under a floating exchange rate system.
Q2Define 'depreciation' of a currency.Show answer
Answer: A fall in the value of a currency against another currency under a floating exchange rate system.
Q3What is the key difference between a fixed and a floating exchange rate system?Show answer
Answer: A fixed exchange rate is pegged to another currency and defended by the central bank; a floating exchange rate is determined purely by market demand and supply, with no central bank intervention.
Q4Give one factor that would increase demand for sterling.Show answer
Answer: For example, a rise in UK interest rates relative to other countries, a rise in UK exports, or an increase in inward foreign direct investment.
Q5The euro moves from 1.15 euros per pound to 1.20 euros per pound. Calculate the percentage change and state whether sterling has appreciated or depreciated.Show answer
Answer: (1.20 - 1.15) / 1.15 x 100 = 4.35%. Since one pound now buys more euros, sterling has appreciated.
Q6Explain in one sentence why a cut in UK interest rates could cause the pound to depreciate.Show answer
Answer: Lower UK interest rates make sterling assets less attractive to international investors seeking a return, reducing demand for sterling and increasing supply as funds move elsewhere.
Q7Name one example of a managed exchange rate system in practice.Show answer
Answer: A currency where the central bank normally allows market forces to set the rate but occasionally buys or sells its own currency, or adjusts interest rates, to prevent excessive volatility.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain two factors that could cause the sterling exchange rate to appreciate against the US dollar.
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Evaluate the likely causes of a sustained depreciation of sterling against the US dollar over an extended period.
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See real A Level Economics past-paper questions, with official mark schemes →
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