4.1.8 Exchange Rates
Edexcel A-Level Economics (9EC0) | Theme 4.1.8
Exchange Rate Systems
A floating exchange rate has its value determined by market forces of demand and supply on the foreign exchange market.
Appreciation means an increase in the value of a currency, while depreciation means a fall in its value.
A fixed exchange rate is pegged to another currency by the central bank.
Revaluation is the official raising of a fixed peg, while devaluation is the official lowering of the peg.
A managed exchange rate (dirty float) allows market forces to operate, but the central bank intervenes to keep the currency within a target range.
Factors Influencing Floating Exchange Rates
Changes in the demand for a currency or the supply of a currency cause its value to change.
| Factor causing an appreciation | Factor causing a depreciation |
|---|---|
| Higher relative interest rates leading to hot money inflows | Lower relative interest rates leading to hot money outflows |
| Lower relative inflation, making exports more competitive | Higher relative inflation, making exports less competitive |
| Higher inward FDI into the UK | Higher outward FDI by UK firms abroad |
| Current account surplus | Current account deficit |
| Positive speculation about the currency or economy | Quantitative easing, which increases the money supply |
Government Intervention in Managed Systems
- To appreciate a currency, the central bank can buy its own currency using foreign reserves or raise interest rates.
- To depreciate a currency, the central bank can sell its own currency or lower interest rates.
Impacts of a Depreciation
- Exports: Exports become cheaper for foreign buyers, so demand is likely to rise.
- Imports: Imports become more expensive for domestic consumers, so demand is likely to fall.
- Current account: The balance is likely to improve over time if the Marshall-Lerner condition holds, where \( PED_x + PED_m > 1 \). In the short run, there may be a deterioration because of the J-curve effect.
- Economic growth: Higher net exports increase aggregate demand and may raise growth.
- Inflation: Imported raw materials and finished goods become more expensive, creating cost-push inflation, and stronger demand may also create demand-pull inflation.
- Unemployment: Employment may rise if export industries expand.
- Living standards: The effect is mixed because imported goods become dearer, although wages and jobs may improve in some sectors.
Impacts of an Appreciation
An appreciation tends to have the opposite effects to a depreciation.
- Exports become less competitive and imports become cheaper.
- The current account may worsen if exports fall and imports rise.
- Inflationary pressure may fall because imported goods and raw materials are cheaper.
- Growth and employment may weaken if net exports decline.
Competitive Devaluation
Competitive devaluation is when a government deliberately pushes down the value of its currency to make exports cheaper and gain a trade advantage.
The risks include:
- Retaliation from other countries
- Trade or currency wars
- Higher import costs
- Inflationary pressure
Exam Preparation
- Define clearly the difference between floating, fixed, and managed exchange rate systems.
- Use a currency market diagram to show how appreciation or depreciation happens.
- Analyse the causes of exchange rate changes by linking them to demand and supply for the currency.
- Evaluate depreciation carefully by discussing the current account, inflation, growth, unemployment, and living standards.
- Apply the key conditions by explaining the Marshall-Lerner condition and the J-curve effect.