# Exchange rates

> CIE A-Level Economics · International Finance and Globalisation
> Source: https://www.owlsprep.com/study/cie-9708-u8-exchange-rates/

This module covers core exchange rate concepts, measurement, determination under different systems, factors driving fluctuations, and macroeconomic impacts, aligned to CIE A-Level 9708 assessment objectives.

**Prerequisites:** [Basic supply and demand analysis](https://www.owlsprep.com/study/cie-9708-u2-supply-and-demand/); [Balance of payments accounting](https://www.owlsprep.com/study/cie-9708-u8-balance-of-payments/)

## Learning objectives

- Distinguish between nominal and real exchange rates and calculate both
- Explain how exchange rates are determined under floating and fixed systems
- Analyze factors that cause exchange rate fluctuations
- Evaluate the impact of exchange rate changes on macroeconomic indicators

## Core Definitions and Measurement

An exchange rate is the price of one national currency expressed in terms of another. It acts as the key link between domestic and international prices for goods, services and financial assets.

**Nominal vs Real Exchange Rate** — Nominal exchange rate: the current market price of one currency in terms of another, unadjusted for inflation. Real exchange rate adjusts for relative price levels between two countries to measure relative purchasing power.

*Notation:* Nominal = $E$, Real = $E_r$

*Example:* If 1 GBP = 1.25 USD and UK prices are 5% higher than US prices, the real exchange rate of GBP against USD is ~1.31.

**Worked example:** The nominal exchange rate is 1 USD = 80 Indian Rupees (INR). The price level index in India is 150, and in the US it is 110 (base year = 100 for both). Calculate the real exchange rate expressed as INR per USD.

1. Recall the standard formula for real exchange rate, where domestic = India, foreign = US:
2. $$E_r = E \times \frac{P_{domestic}}{P_{foreign}}$$
3. Substitute the given values: $E = 80$, $P_{domestic} = 150$, $P_{foreign} = 110$
4. $$E_r = 80 \times \frac{150}{110} \approx 109.1$$
5. The real exchange rate is ~109.1 INR per USD, meaning the USD has higher purchasing power in India than the nominal rate suggests.

## Exchange Rate Determination: Floating Systems

Under a floating (flexible) exchange rate system, the value of a currency is determined by free market forces of supply and demand in the foreign exchange market, with no central bank intervention to fix the rate.

**Appreciation and Depreciation** — Appreciation is an increase in the value of a currency caused by excess market demand. Depreciation is a decrease in value caused by excess market supply.

- Higher foreign demand for domestic exports shifts demand right → currency appreciation
- Higher domestic demand for foreign imports shifts supply right → currency depreciation
- Higher relative domestic interest rates attract foreign capital → demand shifts right → appreciation
- Higher relative domestic inflation reduces export competitiveness → demand falls, supply rises → depreciation
- Speculative expectations of appreciation increase current demand → immediate appreciation

**Worked example:** The Bank of England raises interest rates relative to the US Federal Reserve. Ceteris paribus, what is the impact on the value of GBP against USD?

1. Higher UK interest rates mean higher returns on UK assets compared to US assets. This attracts US investors to buy GBP to invest in UK assets.
2. Demand for GBP shifts right, while supply of GBP shifts left (UK investors are less likely to buy USD for US investments). This changes the equilibrium exchange rate:
3. $$\text{Original equilibrium: } 1 \text{ GBP} = 1.25 \text{ USD} \rightarrow \text{New equilibrium: } 1 \text{ GBP} = 1.32 \text{ USD}$$
4. We conclude that GBP has appreciated against the USD, as each pound now buys more dollars.

> **Exam tip:** Always clarify which currency you are referencing. Examiners penalise ambiguous statements that do not clearly state whether a currency has appreciated or depreciated relative to another.

## Exchange Rate Determination: Fixed Systems

Under a fixed exchange rate system, the central bank pegs the value of the domestic currency to another major currency (e.g. USD, euro) or a basket of currencies, and intervenes in the foreign exchange market to maintain the peg at its target value.

**Devaluation and Revaluation** — Devaluation is a deliberate downward adjustment of the target peg, reducing the value of the domestic currency. Revaluation is a deliberate upward adjustment, increasing the value of the domestic currency.

If the peg is set above the equilibrium market value, the central bank must buy excess domestic currency using its foreign exchange reserves, which can lead to reserve depletion if the imbalance persists. If the peg is set below equilibrium, the central bank sells domestic currency to meet excess demand, accumulating foreign reserves.

**Worked example:** China pegs the RMB to the USD at 1 USD = 7 RMB, but the free market equilibrium would be 1 USD = 6 RMB. What action must the People's Bank of China take to maintain the peg?

1. At the pegged rate of 7 RMB per USD, USD is overvalued and RMB is undervalued. There is excess demand for RMB because it is cheaper than its equilibrium value.
2. To meet this excess demand and prevent RMB from appreciating to its equilibrium level, the PBoC must:
3. 1. Sell additional RMB into the foreign exchange market to increase supply of RMB
2. Buy USD to increase demand for USD
4. This policy maintains the undervalued RMB, making Chinese exports cheaper on global markets to support export-led growth.

## Impacts of Exchange Rate Changes

Exchange rate changes affect the current account of the balance of payments, domestic output, inflation and employment. A depreciation makes domestic exports cheaper for foreign buyers and imports more expensive for domestic consumers, ceteris paribus.

> **Marshall-Lerner Condition**
>
> Depreciation only improves the current account balance if the sum of the price elasticity of demand for exports and the price elasticity of demand for imports is greater than 1. If the sum is less than 1, depreciation worsens the current account deficit.

**Worked example:** A country has a current account deficit. The price elasticity of demand for exports is 0.6, and the price elasticity of demand for imports is 0.3. Will a depreciation eliminate the deficit?

1. First calculate the sum of the elasticities to test the Marshall-Lerner condition:
2. $$PED_{exports} + PED_{imports} = 0.6 + 0.3 = 0.9$$
3. The sum (0.9) is less than 1, so the Marshall-Lerner condition is not satisfied.
4. The volume increase of exports and reduction of imports is not large enough to offset the higher price of imports, so depreciation will actually worsen the current account deficit.

## Common pitfalls

- **Wrong:** Confusing appreciation/depreciation with devaluation/revaluation
  - Why it fails: These terms are specific to the exchange rate system, and mixing them up loses marks in exams
  - Correct: Use appreciation/depreciation for market-driven changes under floating systems, and devaluation/revaluation for deliberate policy changes under fixed systems
- **Wrong:** Forgetting to adjust for inflation when asked to calculate real exchange rates
  - Why it fails: Nominal exchange rates do not reflect relative purchasing power, which is what the question asks for when requesting the real rate
  - Correct: Always use the formula $E_r = E \times \frac{P_d}{P_f}$ when calculating real exchange rates with given inflation/price level data
- **Wrong:** Claiming depreciation always improves the current account balance
  - Why it fails: The impact of depreciation depends on the price elasticities of demand for exports and imports
  - Correct: Always reference the Marshall-Lerner condition before concluding the impact of depreciation on the current account
- **Wrong:** Describing an exchange rate change without specifying which currency it relates to
  - Why it fails: 1 GBP = 1.25 USD means the opposite of 1 USD = 1.25 GBP, so ambiguous answers are marked incorrect
  - Correct: Always clearly state the value of one currency in terms of the other when describing exchange rate changes

## Cheatsheet

| Concept | Key Definition | Key Formula/Rule |
| --- | --- | --- |
| Nominal Exchange Rate | Price of one currency in another, unadjusted | N/A |
| Real Exchange Rate | Inflation-adjusted rate measuring purchasing power | $E_r = E \times \frac{P_d}{P_f}$ |
| Appreciation | Market-driven currency value increase (floating) | N/A |
| Depreciation | Market-driven currency value decrease (floating) | N/A |
| Devaluation | Policy-driven currency value decrease (fixed) | N/A |
| Revaluation | Policy-driven currency value increase (fixed) | N/A |
| Marshall-Lerner Condition | Depreciation improves current account if: | $PED_x + PED_m > 1$ |

## What's next

Exchange rates are a core foundation for analysing international macroeconomics and the impacts of globalisation on domestic economies. Mastering core concepts here prepares you to evaluate the costs and benefits of different exchange rate systems, and how exchange rate policy interacts with core macroeconomic goals like low inflation, full employment and balanced economic growth. You will next explore how exchange rate regimes are chosen, and how they perform during economic shocks.

- [Fixed vs Floating Exchange Rate Systems](https://www.owlsprep.com/study/cie-9708-u8-fixed-vs-floating-exchange-rates/)
- [Balance of Payments Accounts](https://www.owlsprep.com/study/cie-9708-u8-balance-of-payments/)
- [Exchange rate systems](https://www.owlsprep.com/study/cie-9708-u8-exchange-rate-systems/)

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