Exchange rates

CIE A-Level Economics· 40 min read

1. Core Definitions and Measurement★★☆☆☆⏱ 10 min

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.

📘 Definition

Nominal vs Real Exchange Rate

Nominal = $E$ , Real = $E_{r}$

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.

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: $E = 80$ , $P_{d o m es t i c} = 150$ , $P_{f or e i g n} = 110$
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.

2. Exchange Rate Determination: Floating Systems★★★☆☆⏱ 15 min

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.

📘 Definition

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.

3. Exchange Rate Determination: Fixed Systems★★★☆☆⏱ 15 min

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.

📘 Definition

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.

4. Impacts of Exchange Rate Changes★★★★☆⏱ 15 min

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.

📐 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.

5. Common Pitfalls

Wrong move:

Confusing appreciation/depreciation with devaluation/revaluation

Why:

These terms are specific to the exchange rate system, and mixing them up loses marks in exams

Correct move:

Use appreciation/depreciation for market-driven changes under floating systems, and devaluation/revaluation for deliberate policy changes under fixed systems

Wrong move:

Forgetting to adjust for inflation when asked to calculate real exchange rates

Why:

Nominal exchange rates do not reflect relative purchasing power, which is what the question asks for when requesting the real rate

Correct move:

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 move:

Claiming depreciation always improves the current account balance

Why:

The impact of depreciation depends on the price elasticities of demand for exports and imports

Correct move:

Always reference the Marshall-Lerner condition before concluding the impact of depreciation on the current account

Wrong move:

Describing an exchange rate change without specifying which currency it relates to

Why:

1 GBP = 1.25 USD means the opposite of 1 USD = 1.25 GBP, so ambiguous answers are marked incorrect

Correct move:

Always clearly state the value of one currency in terms of the other when describing exchange rate changes

6. Quick Reference 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:	$P E D_{x} + P E D_{m} > 1$

When this came up on past exams

AI-estimated based on syllabus patterns — cross-check with official past papers for accuracy. Use only as revision-focus signals.

2022 · 2
Analyze effects of currency depreciation
2023 · 4
Calculate real exchange rate
2021 · 3
Explain factors of exchange rate changes

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.