Cambridge IGCSE Economics 0455
Syllabus points
- Define the foreign exchange rate.
- Explain how it is determined and the causes of changes.
- Explain the consequences of appreciation and depreciation.
What is an exchange rate?
The foreign exchange rate is the price of one currency in terms of another — for example, £1 = $1.25. In a floating system, exchange rates are set by the demand for and supply of a currency on the foreign exchange market.
Key definitions
| Term | Definition |
|---|---|
| Exchange rate | The price of one currency in terms of another. |
| Appreciation | A rise in the value of a currency (floating system). |
| Depreciation | A fall in the value of a currency (floating system). |
What changes the exchange rate?
A currency's value rises when demand for it rises or supply falls. Causes include:
- Trade — high demand for a country's exports raises demand for its currency (appreciation).
- Interest rates — higher rates attract foreign savers, raising demand for the currency.
- Investment — foreign firms buying into the country demand its currency.
- Speculation — traders buying a currency they expect to rise.
Effects of appreciation and depreciation
Use the memory aid SPICED — Strong Pound, Imports Cheaper, Exports Dearer:
- Appreciation (stronger currency): exports become more expensive abroad and imports cheaper → exports may fall, imports may rise.
- Depreciation (weaker currency): exports become cheaper abroad and imports dearer → exports may rise, imports may fall.
Appreciation → dearer exports, cheaper imports. Depreciation → cheaper exports, dearer imports.
Worked example
A country's currency depreciates by 10%. Its exports become cheaper for foreign buyers, so export sales rise, helping firms and jobs. But imported goods and raw materials become more expensive, which can raise costs and inflation at home. So depreciation helps exporters but can push up import prices.
Common exam mistakes
- Getting the effects backwards (appreciation makes exports *dearer*, not cheaper).
- Confusing depreciation (floating) with devaluation (fixed system).
Exam technique
State whether the currency has appreciated or depreciated, then use "SPICED" to explain the effect on exports, imports and the trade balance.
Quick revision
- Exchange rate = price of one currency in another; set by demand and supply.
- Appreciation → exports dearer, imports cheaper. Depreciation → the reverse.