AQA A-level Economics: Exchange rate systems and currency unions (7136) – Practice Questions

These are original questions written for Marlbridge, for revision and practice on this content. They are not reproduced past-paper questions, and they do not replicate the exam’s exact structure, question count or mark tariffs – examination boards hold copyright in their own papers. Use these alongside the official past papers from your board or school.

These questions cover exchange rate systems and currency unions for AQA A-level Economics (7136), specification version 1.3, PDF section 4.2.6.4 (numbered 3.2.6.4 on the AQA website). Every figure is invented, set in Country E (currency: the E-unit) and Country F (the F-unit). Prices are quoted as F-units per E-unit. Read the study guide and revision notes first. Course pages: AQA A-level Economics hub and the checklist. The free diagnostics show what to revise. Mark splits in the answers are Marlbridge’s own guide.

Questions

1. Explain what is meant by a freely floating exchange rate system. [2]

2. Explain two reasons why demand for the E-unit might rise. [4]

3. In the market for the E-unit, demand is D = 220 − 80P and supply is S = 20 + 120P, where P is the price in F-units and quantities are in millions of E-units a week. (a) Calculate the equilibrium price and quantity. [2] (b) Foreign demand for E’s exports falls, and demand becomes D = 180 − 80P. Calculate the new equilibrium price and the percentage change in the value of the E-unit. [3]

4. Country E now fixes its rate at the original equilibrium of 1.00, but demand falls as in question 3(b). Its central bank holds reserves of 120 million F-units. (a) Calculate the weekly excess supply of E-units at 1.00. [2] (b) Calculate how many weeks the bank can defend the rate by buying E-units. [2]

5. Explain how a rise in interest rates could support the value of the E-unit, and state one cost of doing so. [4]

6. The rate falls from 1.50 to 1.35 F-units per E-unit. An E export is priced at 600 E-units. An F import is priced at 405 F-units. (a) Calculate the F-unit price of the export before and after. [2] (b) Calculate the E-unit price of the import before and after, and the percentage rise. [3]

7. Distinguish between a devaluation and a depreciation. [3]

8. Evaluate the view that a small, open economy should fix its exchange rate. [9]

9. An exporter in a country about to join a currency union sells 8 million F-units of goods a year. Conversion margins cost 1.5% of this, and hedging costs 0.5%. Annual profit is 2.5 million. Calculate the yearly saving and express it as a percentage of profit. [3]

10. A currency union sets one interest rate of 2%. Member X has inflation of 4% and Member Y has 0%. (a) Calculate the exact real interest rate in each member. [2] (b) Explain one problem this creates for the union. [4]

11. Evaluate whether a country with high inflation and a weak currency would gain from joining a currency union. [12]

Answers

1. Market buyers and sellers of the currency alone fix its price [1], with no official target and no routine central bank action [1]. [2] Examiner insight: Answers earn more when they name both halves: how the price is set and the absence of a target.

2. First reason: foreign buyers want more of E’s exports [1], so they need more E-units to pay for them, which shifts demand right [1]. Second reason: higher interest rates in E [1] attract foreign savings, which also need E-units [1]. [4] Examiner insight: A reason usually gains more credit when it is followed by the link to the demand curve, not just named.

3. (a) Set D = S: 220 − 80P = 20 + 120P [1], so 200 = 200P. P = 1.00 F-unit, Q = 140 million [1]. [2] (b) 180 − 80P = 20 + 120P gives 160 = 200P [1]. P = 0.80 [1]. Change = (0.80 / 1.00 − 1) × 100 = −20%, a depreciation [1]. [3] Examiner insight: Write out the step where demand is set equal to supply, so that a slip later in the arithmetic still leaves visible working.

4. (a) At 1.00: demand = 180 − 80 = 100 [1]; supply = 20 + 120 = 140, so excess supply is 40 million E-units [1]. [2] (b) The bank buys 40 million E-units at 1.00, paying 40 million F-units a week [1]. 120 / 40 = 3 weeks [1]. [2] Examiner insight: Convert the excess supply into the currency that leaves the reserves before dividing.

5. Higher interest rates make E-unit deposits more attractive [1], so foreign savers buy E-units and demand shifts right, raising the rate [1]. A cost is that borrowing becomes dearer [1], which reduces consumption and investment and can lower growth and raise unemployment [1]. [4] Examiner insight: A cost explained through to a macro objective tends to earn more than the bare word “inflation” or “unemployment”.

6. (a) Before: 600 × 1.50 = 900 F-units [1]. After: 600 × 1.35 = 810 F-units [1]. [2] (b) Before: 405 / 1.50 = 270 E-units [1]. After: 405 / 1.35 = 300 E-units [1]. Rise = (300 / 270 − 1) × 100 = 11.1% [1]. [3] Examiner insight: Divide to convert foreign prices into home currency and multiply the other way; mixing them up is a common slip.

7. A devaluation is a deliberate cut by the government in the official rate of a fixed system [1]. A depreciation is a fall in the market-determined rate in a floating system [1], caused by changes in demand and supply, not by an official decision [1]. [3] Examiner insight: Naming the system each term belongs to is what separates the two definitions.

8. Case for: a peg gives certainty to trade and investment [1], which matters when a small economy relies on trade [1]. It can import low inflation if pegged to a stable partner [1]. Case against: interest rates must follow the peg, not the home economy [1]. Reserves are limited, and a peg thought to be wrong invites speculative attack [1]. Chain: a small economy with few reserves defends the rate by raising interest rates, which can cause a recession [1]. Floating allows depreciation to restore competitiveness, though import prices rise [1]. Evaluation: it depends on how closely trade is concentrated on one partner, and on the credibility and reserves of the central bank [1]. Judgement: pegging suits an economy with concentrated trade and strong reserves; otherwise floating or a managed float is safer [1]. [9] Examiner insight: Answers that reach a conditional judgement, saying when the claim holds, usually do better than lists of advantages.

9. Conversion cost: 8,000,000 × 0.015 = 120,000 [1]. Hedging: 8,000,000 × 0.005 = 40,000, so the saving is 160,000 a year [1]. As a share of profit: 160,000 / 2,500,000 = 6.4% [1]. [3] Examiner insight: Add both cost lines before the percentage; an answer that uses one cost only will not match.

10. (a) Member X: 1.02 / 1.04 − 1 = −1.9% [1]. Member Y: 1.02 / 1.00 − 1 = +2.0% [1]. [2] (b) The union rate is below inflation in X, so borrowing is cheap in real terms [1] and may fuel a boom and further inflation [1]. In Y the real rate is positive, which restrains spending [1] and may leave growth weak [1]. One rate cannot suit both, and neither member can set its own rate or adjust its exchange rate. [4] Examiner insight: A comparison of two members makes the one-rate problem concrete, which a general statement does not.

11. Gains: the weak currency and high inflation may signal low credibility [1]. Joining a union with a credible central bank can bring lower inflation expectations [1] and lower interest rates [1]. There are no conversion costs or exchange rate risk [1], which can raise trade and FDI [1]. Losses: the country cannot depreciate to regain competitiveness [1]. If its prices stay high it will have to cut costs by internal devaluation [1], with unemployment and lower output [1]. It gives up an independent interest rate [1], and the union rate may not suit it [1]. Evaluation: much depends on whether it can bring inflation down first, and on flexibility of wages [1]. Judgement: if it has failed to control inflation alone, the credibility gain may outweigh the loss, but only if wages and prices can adjust quickly [1]. [12] Examiner insight: A stronger answer ties the judgement to the country’s own starting point, high inflation, rather than giving a general view of unions.

Where marks are usually lost

• Drawing the vertical axis for the wrong currency and shifting the wrong curve.
• Writing “the currency appreciates” when the system is fixed and the term needed is revaluation.
• Skipping the line where demand equals supply in a calculation.
• Stating that intervention is free, with no mention of reserves.
• Giving a cost of higher interest rates without linking it to a macroeconomic objective.
• Calculating a percentage change of the wrong currency.
• Listing currency union points without applying them to the country in the question.
• Closing an evaluation with a restatement but no supported judgement.

Next steps

• Re-read the revision notes and the study guide.
• Use the printable checklist and the AQA A-level Economics hub to plan your next topic.
• Take all free 10-minute diagnostics to check other topics.
• Book a free trial class.

Official syllabus

AQA, AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, section 4.2.6.4 (Exchange rate systems).