Foreign Exchange Rates

What is an exchange rate?

The foreign exchange rate is the price of one currency in terms of another, for example £1 = $1.25.

Two systems:

• Floating exchange rate: the rate is set by demand for and supply of the currency in the foreign exchange market, with no government intervention.
• Fixed exchange rate: the government or central bank sets the rate and maintains it by buying or selling its own currency using reserves.

The vocabulary depends on the system, and examiners check it:

Using "devaluation" for a market-driven fall is the single most common error in this topic.

How a floating rate is determined

The rate settles where demand equals supply for the currency.

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Demand for a country's currency comes from:

• Foreigners buying its exports; they must obtain the currency to pay.
• Foreign investment into the country.
• Speculators who expect the currency to rise.
• Tourists visiting the country.

Supply of the currency comes from:

• Residents buying imports; they must sell their currency to obtain foreign currency.
• Investment going abroad.
• Residents travelling abroad as tourists.

Causes of changes

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Consequences of a depreciation

The core effect: exports become cheaper abroad, imports become dearer at home.

A memory aid used widely: SPICED, Stronger Pound, Imports Cheaper, Exports Dearer. A depreciation is the reverse.

1. The currency falls
2. domestic goods cost less in foreign currency
3. export demand rises
4. and foreign goods cost more at home
5. import demand falls
6. the current account may improve
7. higher demand for domestic output raises output and employment.

But there are costs:

• Imported goods cost more, so the cost of living rises.
• Imported raw materials and components cost more, raising firms' costs and causing cost-push inflation (4.8).
• The improvement depends on elasticity: if demand for exports and imports is inelastic, volumes barely change and the current account may worsen at first.

Consequences of an appreciation

The mirror image: exports become dearer and imports cheaper.

• Exporters lose competitiveness; export volumes fall.
• Output and employment may fall in export industries.
• Imports are cheaper, which lowers the cost of living and helps firms that use imported inputs, so appreciation reduces inflationary pressure.
• The current account is likely to worsen.

Worked example

A country's currency depreciates by 15% against its trading partners.

1. Its goods now cost 15% less in foreign currency
2. foreign buyers demand more
3. export revenue rises, provided demand is reasonably elastic
4. meanwhile imports cost 15% more, so households and firms buy fewer of them
5. the current account improves
6. higher net exports raise demand for domestic output, so output and employment rise.

The costs, which the best answers include:

Imported food, fuel and consumer goods all cost more

the cost of living rises.

Firms using imported components face higher costs

cost-push inflation, which erodes the competitiveness gain over time.

• If demand for exports is inelastic, the extra volume may not make up for the lower price, and the current account may not improve at all.

Judgement: a depreciation helps exporters and employment in the short run, but only improves the current account if demand is sufficiently elastic, and it raises inflation, which eventually undoes some of the advantage.

Common exam mistakes

• Using devaluation for a market movement; that is depreciation.
• Getting SPICED backwards.
• Saying a depreciation is simply good, ignoring imported inflation.
• Forgetting that a depreciation raises the cost of imported raw materials for domestic firms.
• Ignoring elasticity when judging the effect on the current account.
• Confusing demand for and supply of the currency. Remember imports supply the domestic currency.

Exam technique

State clearly whether the currency has appreciated or depreciated before discussing effects, and use the right word for the exchange rate system.

Then trace the chain: exchange rate → export and import prices → volumes → current account → output and employment.

For evaluation, use elasticity, imported inflation, and the fact that different groups are affected differently, exporters gain from a depreciation while importers and consumers lose.

Building an answer

4 marks, "Explain the effect of a depreciation on a country's exports and imports."

A weaker currency means exports become cheaper when priced in foreign currency, so foreign buyers demand more and export volumes rise.
Imports become more expensive in domestic currency, so buyers switch to domestic substitutes and import volumes fall.

6 marks, "Analyse the effects of a currency appreciation on an economy."

Exports become more expensive abroad, so export demand falls, reducing output and employment in exporting industries.
Imports become cheaper, which lowers the price of imported raw materials and finished goods, helpful for inflation, and for firms that import components.
Net trade therefore worsens, reducing total demand, though the fall in import prices eases cost-push inflationary pressure.
The size of the effect depends on elasticity: if demand for exports and imports is inelastic, quantities change little and the main effect falls on the value of trade rather than its volume.

SPICED is the mnemonic worth carrying into the exam: Strong Pound, Imports Cheap, Exports Dear.

What moves an exchange rate

Floating against fixed

A floating rate is set by demand and supply in the foreign exchange market: it adjusts automatically to trade imbalances, and the central bank keeps its freedom to set interest rates for domestic purposes. A fixed rate is held at a set value by the central bank buying and selling its own currency: it gives certainty for traders and investors, but requires large reserves and ties monetary policy to defending the peg.

A real case to quote

Sterling after June 2016. The pound fell roughly 10% against the dollar within days. Exporters and tourism gained competitiveness; import prices rose and CPI inflation climbed above 3% within a year, squeezing real wages. It gives you both sides of a depreciation with dates and numbers, which is exactly what an evaluation needs.

Quick revision

• Exchange rate = price of one currency in another.
• Floating = set by demand and supply. Fixed = set by the authorities.
• Appreciation/depreciation = market. Revaluation/devaluation = policy.
• Demand comes from exports and inward investment; supply from imports and outward investment.
• Higher interest rates → appreciation. Higher domestic inflation → depreciation.
• SPICED: Strong Pound, Imports Cheaper, Exports Dearer.
• Depreciation helps exporters and employment but causes imported inflation.
• Whether the current account improves depends on elasticity.

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