Exchange rates — Edexcel A-Level Economics A
Verified courseTeaching note checked against the official specification.
Exchange rates explained
A floating exchange rate is determined by demand for and supply of a currency in the foreign exchange market.
Read the full explanation
Demand rises when foreigners want to buy exports, invest in domestic assets or hold the currency as a reserve; supply rises when residents buy imports or invest abroad. Factors that shift these flows include relative interest rates, relative inflation rates, speculative flows, current account balances, and central bank intervention. For example, a rise in UK interest rates relative to US rates can attract capital inflows, increasing demand for sterling and causing appreciation. Higher domestic inflation can make exports less competitive, reducing demand and causing depreciation. Speculation can amplify movements. The equilibrium rate changes as these factors alter demand or supply, and the effect on the rate depends on the direction and size of the shift.
Your focus
- Explain how relative interest rates, relative inflation, speculation, current account balances and central bank intervention influence a floating exchange rate.
- Use demand and supply analysis to show how a factor causes appreciation or depreciation.
- Distinguish between factors that shift demand or supply and movements along the curves caused by a change in the exchange rate.
Exchange rates exam tips
Marking Points
- Relative interest rates: higher domestic interest rates can attract capital inflows, increasing demand for the currency and causing appreciation.
- Relative inflation rates: higher domestic inflation can reduce export competitiveness and increase import demand, causing depreciation.
- Speculation: expectations of future currency movements can cause buying or selling that shifts demand or supply and changes the rate.
- Current account balance: a larger deficit can increase supply of the currency through import payments, putting downward pressure on the rate.
- Central bank intervention: buying or selling currency can shift demand or supply and influence a floating rate, though the float is primarily market-determined.
Examiner Tips
- 💡State the factor and then explain which curve it shifts: demand for the currency or supply of the currency.
- 💡Use a relative comparison, such as UK interest rates relative to another country, to show why the flow changes.
- 💡Link the shift to a clear outcome: appreciation or depreciation, and mention that the size of the effect depends on the scale of the shift.
Common Mistakes
- Confusing a movement along the demand or supply curve with a shift: the error is treating a change in the exchange rate itself as a factor; the correction is that factors influence the rate by shifting demand or supply.
- Assuming higher interest rates always appreciate the currency: the error is ignoring expectations and risk; the correction is that the effect depends on whether the rate rise was anticipated and on other flows.
- Ignoring the role of speculation: the error is analysing only trade flows; the correction is that expectations and speculative capital flows can dominate in the short run.
- Treating central bank intervention as the main determinant of a floating rate: the error is overstating official action; the correction is that in a floating system the rate is primarily set by market demand and supply.