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Topic 4.3
Exchange Rates
In this topic, you will learn about the different types of currencies and exchange rates, and how the demand and supply of currencies interact to set their value. You will also learn about the economic cycle, and its link to exchange rates.
Currencies and Exchange Rates
Currencies
A currency is a generally accepted form of money used in a country or group of countries, including coins and paper notes, which is issued by a government and circulated within an economy.
Exchange Rates
The exchange rate is the value of one currency in comparison to another.
Types of Exchange Rates
Fixed Exchange Rates
A fixed exchange rate is when the value of a currency is pegged to another currency by the central bank.
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When they want it to appreciate (grow in value) then buy it on the forex market (foreign exchange market) using their foreign reserves to increase demand.
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When they want it to depreciate (fall in value), they sell it on the forex markets to increase supply
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An example is the Hong Kong Dollar which is pegged to the US Dollar at the rate 7.75 HKD: 1 USD
Floating Exchange Rates
A floating exchange rate is a system where a currency’s value is determined purely by market forces—supply and demand—without intervention from governments or central banks. This causes the currency's value to fluctuate naturally over time.
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Examples: The US Dollar (USD) and British Pound (GBP).
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When a floating currency like the USD changes in value, countries with currencies pegged to the USD will automatically see their relative currency values shift too. To maintain that fixed exchange rate, the pegged country's central bank must actively step in using foreign reserves to keep their currency locked to the USD.
What does demand and supply for currencies actually mean?
The demand for a currency simply means how much people, businesses, and investors want to hold or use that currency at a given time. Currency supply is simply the total amount of that currency available in the economy at a given time.
Factors Affecting the Demand for the Pound
Interest Rates
Higher UK interest rates attract foreign investment ('hot money'), increasing the demand for pounds as investors seek better returns.
Speculation
If currency traders believe the pound will strengthen in the future, they will buy it now, increasing current demand.
Political Stability
Stable governments and clear policies build investor confidence, while political chaos drives demand down.
Relative Inflation
Lower relative inflation in the UK makes UK goods more attractive compared to foreign goods, increasing export demand and demand for pounds.
Export Demand
If UK goods become more competitive abroad, foreign buyers must purchase pounds to pay for these exports, driving up demand.
Economic Growth
Strong UK growth boosts investor and business confidence, driving capital inflows and demand for the pound. Growth in trading partners also lifts demand for UK exports and the currency.
Factors Affecting the Supply of the Pound
Interest Rates
Lower UK interest rates encourage domestic investors to sell pounds and move capital abroad for better returns. Higher interest rates abroad also cause hot money outflow.
Speculation
If currency traders expect the pound to depreciate, they sell their holdings immediately, rapidly increasing market supply
Outbound investment
UK businesses and individuals purchasing foreign assets, businesses, or real estate must sell pounds to fund those transactions.
Relative Inflation
High relative UK inflation makes foreign imports cheaper for UK consumers, increasing the supply of pounds as they sell them for foreign currency
Import Demand
When UK consumers buy more foreign goods and services, they must sell pounds to pay for them
Economic Growth
Strong UK growth means that people have more income so import demand rises and hence the supply of the pound also rises.
WPIDEC and SPICED
WPIDEC
Weak Pound: Imports Dearer, Exports Cheaper. A weak pound makes imports more expensive (dearer) because each pound buys less foreign currency, while it makes exports cheaper since goods become more affordable for buyers overseas.
W: Weak Pound
P: Pound
I: Imports
D: Dearer
E: Exports
C: Cheaper
SPICED
Strong Pound: Imports Cheaper, Exports Dearer. A strong pound makes imports cheaper because each pound buys more foreign currency, while it makes exports dearer since goods become more expensive for buyers overseas.
S: Strong
P: Pound
I: Imports
C: Cheaper
E: Exports
D: Dearer
Above GCSE Level!
Marginal Propensities
Marginal propensity is the proportion of extra disposable income that a household will choose to spend on a specific economic activity, such as spending, saving, or importing. The sum of all marginal propensities (MCP + MPS + MPT + MPM) always equals 1 (where MPT is marginal propensity to tax). MPM values are different for every person.
MPC: Propensity to Consume
The proportion of an increase in income that a consumer spends on consumption (domestic goods and services).
The Income Divide: Rich vs. Poor:
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High-Income Earners: Have a higher MPS and a lower MPC because their basic needs are already met, allowing them to save more of their extra cash.
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Low-Income Earners: Have a lower MPS and a higher MPC because they must spend most extra money immediately on living essentials.
Revision Tip: Marginal Propensity is a great point to use as evaluations, as it is above GCSE level and shows your deep knowledge of the subject. For example, the size of AD multipliers depends on MPC (if MPC is greater, then there will be a greater increase in consumption). Another example is that imports might not rise as much when the pound appreciates as it depends on the consumers MPM.
MPS: Propensity to Save
The proportion of an increase in income that is saved rather than spent on current consumption.
MPM: Propensity to Import
The proportion of an increase in income that is spent on imports from other countries.
The pound appreciates so imports rise and exports fall, causing a trade deficit (SPICED)
The Floating Exchange Rate Self-Correcting Mechanism
AD shifts left which reduces derived demand for labour and wages fall and imports decrease
The demand for the pound falls and the pound depreciates.
Due to WPIDEC, exports rise and imports fall creating a trade surplus, and AD shifts right
There is more demand for the pound.
Evaluating the consequences of a fall in exchange rate to consumers/producers
Points
Evaluations
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The fall in exchange rates allows more foreign investment (FDI) into the country, so there will be a crowding in effect. There will be increased employment, with better quality goods and services available for consumption. Domestic firms will also gain external economies of scale.
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The depreciation means that exports are cheaper for foreign consumers (due to WPIDEC) and domestic firms will make more revenue. This means that domestic firms will need to increase production to match the increased demand, which will reduce unemployment by increasing derived demand for labour. People who are already employed will receive wage increases which can be spent on better quality goods and services, increasing the quality of life.
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The FDI might cause a crowding out effect if the foreign companies compete for scarce resources with domestic firms
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The increase in export depends on marginal propensities: export demand might not increase by much if MPC is low and MPS is high
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The increase in export demand also depends on the PED for the goods and services being exported
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Due to the Exchange Rate self-correcting mechanism, the increased quality of life is short-term.
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Key Tip: Make sure to check whether the question asks you about producers or consumers.
Evaluating the consequences of a rise in exchange rates to consumers/producers
Points
Evaluations
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Imports will be cheaper:
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For consumers: More choice, better quality of goods
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For producers: Greater choice and quality of factors of production
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Exports will reduce:
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For consumers: less derived demand for labour, so lower wages and lower employment
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For producers: less revenue
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For producers: cheaper and better
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Exchange Rates Self-Correcting Mechanisms means that imports will fall in the longer-run
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The fall in exports might not be very bad for producers/consumers because it depends on marginal propensities, and PED
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Key Tip: For both appreciation and depreciation, your first point can be about the impact on imports, and the second point about the impact on exports. To evaluate the exports point, you can mention marginal propensities, and to evaluate the imports point, you can mention the self-correcting mechanism in the long-run. This functions as a well developed argument that shows your knowledge of economics past a GCSE level, which considers how exchange rate changes interact with domestic income and foreign demand.