Syllabus points
- Define an exchange rate and distinguish floating from fixed systems.
- Explain how a floating exchange rate is determined by demand and supply.
- Distinguish depreciation/appreciation from devaluation/revaluation.
- Evaluate the consequences of exchange-rate changes.
Key definitions
| Term | Meaning |
|---|---|
| Exchange rate | The price of one currency expressed in terms of another |
| Depreciation | A fall in a currency's value under a floating system |
| Appreciation | A rise in a currency's value under a floating system |
| Devaluation | A deliberate reduction of a fixed exchange rate by the authorities |
| Revaluation | A deliberate increase of a fixed exchange rate by the authorities |
Depreciation/appreciation happen through the market; devaluation/revaluation are policy decisions. Using the wrong pair is one of the most common errors in this topic.
How a floating rate is determined
In a floating system the rate is set where demand for the currency equals supply.
- Demand for a currency comes from foreigners buying its exports, inward investment and speculative inflows.
- Supply comes from domestic residents buying imports, outward investment and speculative outflows.
Causes of a shift include relative interest rates (higher rates attract capital inflows, raising demand), relative inflation rates, relative growth, and speculation.
Consequences of a depreciation
A depreciation makes exports cheaper abroad and imports dearer at home:
- Exports become more price competitive → export volumes may rise.
- Imports become more expensive → import volumes may fall, but imported inputs raise firms' costs.
- Net exports (X − M) may improve, raising AD — but only if demand is sufficiently price elastic.
- Inflation may rise through dearer imports (cost-push) and stronger AD (demand-pull).
The improvement is not immediate: in the short run contracts and habits keep volumes fixed while the import bill rises, so the trade balance can worsen before it improves — the J-curve effect.
Fixed vs floating: evaluation
- Floating: self-correcting, requires no reserves, and frees monetary policy for domestic goals — but is volatile and can be driven by speculation.
- Fixed: provides certainty for traders and investors and imposes inflation discipline — but requires large reserves, ties monetary policy to defending the rate, and can be attacked by speculators.
Worked example
A currency depreciates from $1.50 to $1.20 per unit. A domestic good priced at 100 units now costs foreign buyers $120 instead of $150 — more competitive. But an import invoiced at $300 now costs 250 units instead of 200 — an 25% rise in domestic-currency cost, feeding cost-push inflation.
Common exam mistakes
- Using "devaluation" for a market-driven fall (that is depreciation).
- Assuming a depreciation always improves the current account — it depends on elasticities and the J-curve.
- Forgetting that a depreciation raises imported-input costs for domestic firms.
Exam technique
Draw the currency demand/supply diagram, identify which curve shifts and why, then evaluate using elasticities, the J-curve and the inflation trade-off.
Quick revision
- Floating: set by demand and supply; fixed: set by the authorities.
- Depreciation/appreciation (market) vs devaluation/revaluation (policy).
- Depreciation → cheaper exports, dearer imports; effect depends on elasticities.
- J-curve: the trade balance can worsen before improving.