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

These revision notes condense exchange rate systems 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). Read the full study guide for the explanations. Test yourself with the practice questions. Course pages: AQA A-level Economics hub, checklist and free diagnostics. All figures here are invented, set in Country C (currency: the C-unit) and Country D (the D-unit).

Key definitions

Term	Meaning
Exchange rate	What must be paid in one currency to obtain a unit of another
Freely floating system	The rate is set by market demand and supply, with no government target
Fixed (pegged) system	The government commits to a central rate and defends it
Managed float	Floating, but the central bank intervenes from time to time
Appreciation, depreciation	A rise or fall in a floating rate
Revaluation, devaluation	A deliberate rise or fall in a fixed rate
Foreign exchange reserves	Stock of foreign currency and other assets held by the central bank
Currency union	Countries sharing one currency and one central bank
Hot money	Short-term funds moved to earn a higher interest rate

Floating rate determination

Quote the rate as D-units per C-unit. Demand for the C-unit arises from exports, inward investment, inward savings and speculative buying. Supply arises from imports, outward investment, outflows of savings and speculative selling.

Method in steps:

1. Name the currency whose price you are drawing, and put its price on the vertical axis.
2. Decide whether demand or supply moves, and which way.
3. Read off the new equilibrium rate and quantity.
4. Say whether the currency has appreciated or depreciated, and by how much if numbers are given.
5. Add one consequence, such as dearer exports or cheaper imports.

Event	Curve shift	Result for the C-unit
Higher interest rate in C	Demand right, supply left	Appreciates
Rise in D’s demand for C’s goods	Demand right	Appreciates
Fall in inward investment	Demand left	Depreciates
Rising import spending in C	Supply right	Depreciates
Expected fall in value	Demand left, supply right	Depreciates

Percentage change reminders

If the rate moves from 2.00 to 2.50 D-units per C-unit, the C-unit has risen by (2.50 / 2.00 − 1) × 100 = 25%. Measured the other way, C-units per D-unit fall from 0.50 to 0.40, a 20% fall. The two percentages differ, so say which currency you mean.

• C export priced at 400 C-units: D price rises from 400 × 2.00 = 800 to 400 × 2.50 = 1,000 D-units, a 25% rise.
• Import priced at 300 D-units: C price falls from 300 / 2.00 = 150 to 300 / 2.50 = 120 C-units, a 20% fall.
• A holiday costing 800 D-units: 400 C-units before, 320 C-units after.

When a currency gains value, foreign buyers pay more for its exports while home buyers pay less for imports. A fall in value does the opposite. The effect on spending depends on price elasticity of demand.

Government intervention

Tool	How it works	Limit or cost
Sell the currency	Adds to supply, lowers the rate	Can raise the money supply and inflation
Buy the currency	Adds to demand, raises the rate	Uses up reserves
Raise interest rates	Attracts hot money, shifts demand right	Dearer borrowing, lower AD, possible rise in unemployment
Lower interest rates	Shifts demand left	Risk of higher inflation
Capital controls	Restrict flows in or out	Distort investment, may cause evasion
Devalue or revalue	Reset the fixed rate	Loss of credibility, effect on prices

Defending a floor: a worked reminder

Suppose the central rate is 2.00 with a permitted band of plus or minus 5%. The limits are 2.00 × 0.95 = 1.90 and 2.00 × 1.05 = 2.10. If the rate hits 1.90, the central bank must buy C-units. Absorbing 30 million C-units a week at 1.90 costs 30 × 1.90 = 57 million D-units a week. Reserves of 90 million D-units last 90 / 57 = about 1.6 weeks. So heavy selling pressure drains reserves quickly, and the bank must also change the interest rate, tighten controls or reset the band.

Fixed versus floating

Fixed	Floating
Stable rate helps trade and investment planning	Rate risk, unless firms hedge
Discipline on inflation	Policy freedom
Needs reserves and credibility	Needs few reserves
No automatic correction of a deficit	Depreciation can restore competitiveness
Vulnerable to speculative attack if set at the wrong level	Can overshoot and swing

Must-know distinctions:

• Appreciation (floating) versus revaluation (fixed).
• Intervention in a floating system is occasional; in a fixed system it is the rule.
• A managed float is neither fully fixed nor fully free.

Currency unions

Gains	Losses
No conversion costs or hedging costs inside the union	No national interest rate
No exchange rate risk, so trade and investment may grow	No exchange rate to correct lost competitiveness
Price transparency and more competition	Asymmetric shocks are hard to handle
Credible central bank, possibly lower inflation	Fiscal limits and limited transfers
Larger market for FDI	Loss of national control of money

One interest rate: worked reminder

Union rate 4%. Member P has inflation of 6%, Member R has 2%. Approximate real rates are P: 4 − 6 = −2%; R: 4 − 2 = +2%. Exactly, 1.04 / 1.06 − 1 = −1.9% and 1.04 / 1.02 − 1 = +2.0%. P gets cheap borrowing when it needs restraint; R gets expensive borrowing when it may need stimulus.

Lost competitiveness: worked reminder

If unit labour costs in Member P rise 8% a year faster than its partners’ for 3 years, the cumulative gap is 1.08 × 1.08 × 1.08 = 1.2597, about 26%. A floating currency would need to fall by 1 / 1.2597 − 1 = −20.6% to restore the position. Inside the union the alternative is an internal devaluation, with lower wages and prices and often high unemployment.

Do not confuse a currency union with a customs union. A customs union removes trade barriers between members and sets a common external tariff. A currency union shares money.

A chain of reasoning to learn

Use this pattern for any “explain” or “assess” answer. Cause: interest rates in C rise. Link one: foreign savers want C-unit deposits. Link two: demand for the C-unit shifts right. Link three: the C-unit appreciates. Consequence: C’s exports become dearer abroad and imports cheaper. Evaluation: the net effect on the trade balance depends on elasticity and on how long the change lasts. Finish with a short judgement.

Evaluation toolkit

• Short run versus long run.
• Elasticity of demand for exports and imports.
• Size of reserves and credibility of the central bank.
• How open the economy is.
• Similarity of the economy to its partners.
• Who gains and who loses.

Quick self-test

1. State two causes of a rise in demand for the C-unit.
2. The rate moves from 2.00 to 2.50 D-units per C-unit. Calculate the percentage change in the value of the C-unit.
3. A C export is priced at 400 C-units. Calculate its price in D-units at 2.00 and at 2.50.
4. A D import is priced at 300 D-units. Calculate its price in C-units at 2.00 and at 2.50.
5. In a fixed system with a floor of 1.90, what must the central bank do if the rate falls to it?
6. Calculate the cost, in D-units, of buying 30 million C-units at 1.90.
7. With reserves of 90 million D-units and a cost of 57 million a week, how long can the bank keep going?
8. Define devaluation.
9. Union rate 4%, inflation 6%: calculate the exact real interest rate.
10. Costs rise 8% a year faster than a partner’s for 3 years. Calculate the cumulative gap and the depreciation that would offset it.
11. State one difference between a customs union and a currency union.

Answers

1. Any two from: higher export demand, inward investment, higher interest rates in C, speculative buying.
2. 25% rise.
3. 800 D-units and 1,000 D-units.
4. 150 C-units and 120 C-units.
5. Buy C-units with its reserves, or change interest rates, or reset the band.
6. 30 × 1.90 = 57 million D-units.
7. 90 / 57 = about 1.6 weeks.
8. The government lowers the official value of its pegged rate.
9. 1.04 / 1.06 − 1 = −1.9%.
10. 1.08 cubed = 1.2597, so about 26%; the offset is −20.6%.
11. A customs union removes trade barriers and sets a common external tariff; a currency union shares one currency and one central bank.

Where marks are usually lost

• Drawing price on the axis for the wrong currency, so the shift goes the wrong way.
• Saying a strong currency always helps the economy, with no mention of exporters.
• Describing intervention without saying that reserves are limited.
• Confusing appreciation with revaluation.
• Giving a list of advantages and disadvantages of a currency union with no judgement on which dominates.
• Ignoring elasticity when linking the exchange rate to the trade balance.
• Using the same percentage for both directions of a currency change.
• Forgetting that a union member cannot cut its own interest rate.

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).