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

This study guide covers exchange rate systems for AQA A-level Economics (7136), specification version 1.3. The content is in the PDF’s section 4.2.6.4 (the AQA website numbers it 3.2.6.4). The specification assesses content 14, the international economy, in Paper 2 and in Paper 3. Every figure below is invented, set in Country A and Country B, and is there only to show the method. Trade theory, tariffs, the balance of payments and globalisation are separate units, so this guide stays on exchange rate systems.

Course pages: AQA A-level Economics hub and the checklist. Companion pages: revision notes and practice questions. The free diagnostics show which parts to revise first.

What the specification asks for

Specification point	Skill you need
How exchange rates are determined in freely floating systems	Explain demand and supply of a currency, shifts, and the new equilibrium
How governments can intervene to influence the exchange rate	Explain buying and selling currency, interest rates, devaluation and revaluation
Advantages and disadvantages of fixed and floating systems	Weigh the two systems against each other
Advantages and disadvantages for a country of joining a currency union, eg the eurozone	Assess membership for one country

The specification adds that understanding price elasticity of demand is essential when analysing the impact of changes in the exchange rate on an economy. Keep that in mind when you evaluate.

Floating exchange rates

An exchange rate is what you pay in one currency to get a unit of another. Here it is quoted as the number of B-units that buy one A-unit. In a freely floating system, buying and selling of the currency by market participants alone fixes the rate, and nobody manages it.

Demand for the A-unit comes from buyers who need A-units:

• foreigners buying Country A’s exports of goods and services
• foreign firms and investors making direct investment or buying A-denominated shares and bonds
• savers moving funds to earn higher interest in Country A
• speculators who expect the A-unit to rise

Supply of the A-unit comes from people selling A-units to get foreign currency:

• Country A residents buying imports
• A-based firms and investors investing abroad
• savers moving money out for better returns elsewhere
• speculators who expect the A-unit to fall

The demand curve slopes downward because a cheaper A-unit makes A’s goods cheaper abroad, so more are bought. The supply curve slopes upward because a dearer A-unit makes imports cheaper for A’s residents, so they buy more and supply more A-units. Where the curves cross is the equilibrium rate.

Worked example: a rise in interest rates

Invented market for the A-unit, in millions of A-units per week:

Price of one A-unit (B-units)	0.80	0.90	1.00	1.10	1.20
Demand	140	120	100	80	60
Supply	60	80	100	120	140

Equilibrium is 1.00 B-unit per A-unit, with 100 million traded, because demand equals supply there.

Country A’s central bank raises its interest rate. Foreign savers want to hold A-unit deposits, so demand rises by 30 million at every price:

Price	0.80	0.90	1.00	1.10	1.20
New demand	170	150	130	110	90

At 1.00, demand is 130 and supply is 100, so there is excess demand of 30 and the rate is pushed up. At 1.10, demand is 110 and supply is 120, an excess supply of 10. So equilibrium lies between 1.00 and 1.10. Assuming straight lines between the table points, it is 1.00 + 0.10 × 30/40 = 1.075. Supply there is 100 + 20 × 0.75 = 115, and so is demand (130 − 20 × 0.75). The A-unit has appreciated by (1.075 / 1.00 − 1) × 100 = 7.5%.

Sketch of the change:

Price of A-unit (B-units)
 1.10 |        D new  \
 1.075|---------X------\------ new equilibrium
 1.00 |  X---------------\---- old equilibrium
      |   D old      S
      +-------------------------- Quantity of A-units

In words: the demand curve shifts right, the equilibrium moves up the supply curve, the price rises and the quantity traded rises.

What shifts the curves

Cause	Curve	Effect on the A-unit
Foreign demand for A’s exports rises	Demand right	Appreciates
Higher interest rates in A relative to elsewhere	Demand right, supply left	Appreciates
Inflation in A higher than abroad (A’s goods less competitive)	Demand left, supply right	Depreciates
Foreign direct investment flows into A	Demand right	Appreciates
Speculators expect a fall	Demand left, supply right	Depreciates, which can confirm the expectation

Speculation can be self-fulfilling and can make floating rates swing far from levels that trade alone would justify.

Government intervention

Governments and central banks can influence the rate in three main ways.

1. Buying or selling currency. To raise the A-unit’s value, the central bank buys A-units using its foreign exchange reserves. This adds to demand. To lower it, the bank sells A-units and acquires foreign currency, which adds to supply and builds reserves. Buying is limited by reserves. Selling is not limited, but it can add to the money supply and so to inflation.
2. Changing interest rates. A higher rate attracts hot money and moves demand right, as in the example above. The cost is that borrowing becomes dearer, which slows consumption and investment and can push AD down.
3. Other measures. Capital controls limit flows of money in or out. Fiscal tightening, by cutting spending or raising tax, reduces import demand.

A system with some intervention but no fixed target is a managed float. In a fixed (pegged) system the government sets a central rate, sometimes with a band, and uses the tools above to defend it. A devaluation is a deliberate cut in a fixed rate; a revaluation is a deliberate rise. The words depreciation and appreciation describe moves in a floating rate.

Worked example: defending a peg

Country A fixes the rate at 1.10 B-units per A-unit, above the market-clearing 1.00 in the first table. At 1.10, demand is 80 and supply is 120. There is excess supply of 40 million A-units a week. To hold the rate, the central bank buys 40 million A-units, paying 40 × 1.10 = 44 million B-units from reserves each week. With reserves of 220 million B-units, the bank can keep this up for 220 / 44 = 5 weeks. After that it must raise interest rates, accept a cut in the peg or impose controls.

If the government devalues to 1.00, the fall is (1.00 / 1.10 − 1) × 100 = −9.1%, excess supply disappears, and no more reserves are used. The central rate is then at the market level. Notice that the peg only needed defending because it was set too high.

Fixed versus floating

	Fixed (pegged)	Floating
Certainty for traders	High: less risk in trade and investment contracts	Low: rates vary, so firms may pay for hedging
Discipline on inflation	Strong: a government that inflates faster than the partner loses competitiveness	Weaker
Monetary policy	Interest rates must serve the peg, not the domestic economy	Free to target inflation and growth
Automatic adjustment	None: a deficit has to be corrected by other means	A falling currency can help restore competitiveness
Reserves	Large reserves needed	Little or none needed
Speculation	A peg thought to be wrong invites attacks	Rates can overshoot
Imported inflation	Avoided if the peg is credible	Depreciation raises import prices

Effect of a depreciation on prices

Suppose the A-unit falls from 1.00 to 0.80 B-units, a fall of 20%. An A export priced at 50 A-units costs 50 × 1.00 = 50 B-units before and 50 × 0.80 = 40 B-units after, a 20% fall in the foreign price. A B-good priced at 30 B-units costs 30 / 1.00 = 30 A-units before and 30 / 0.80 = 37.5 A-units after, a 25% rise. The change in quantities depends on price elasticity of demand for exports and imports. If demand is inelastic, spending on imports may rise and the trade balance may worsen at first. That is why elasticity matters in evaluation.

Evaluating the choice

• A fixed rate gives stability, but only if it is credible and set near the equilibrium. If reserves are small, markets may bet against it.
• Floating rates give freedom for monetary policy, but a large depreciation can raise import prices and inflation, especially where the economy relies on imported fuel, food or components.
• The better system depends on the economy’s openness. A small economy that trades mainly with one partner gains more from pegging to that partner’s currency.
• Time matters. In the short run, speculation drives floating rates. In the long run, relative inflation and productivity matter more.

Currency unions

A currency union is a group of countries that share one currency and a common central bank. The eurozone is the example the specification names. Its members use the euro, and the European Central Bank sets one interest rate for all of them.

Advantages for a member:

• No transaction costs of changing currency, and no cost of hedging.
• No exchange rate uncertainty inside the union, which encourages trade and investment.
• Price transparency, so consumers and firms compare prices easily and competition rises.
• A credible, independent central bank may bring lower inflation and lower interest rates to a country with a history of high inflation.
• A bigger market may attract more FDI.

Disadvantages for a member:

• No independent monetary policy: one interest rate has to suit every member.
• No exchange rate to adjust. A member that loses competitiveness cannot depreciate.
• Asymmetric shocks, where a shock hits one member harder, cannot be met with a local interest rate.
• Fiscal limits or a lack of fiscal transfers may leave a weak member to adjust alone.
• Giving up national control of money, which has a political cost.

Worked example: transaction costs

An invented exporter in Country A sells 6 million B-units of goods a year and loses 2% to bank margins when converting. Cost: 6,000,000 × 0.02 = 120,000 B-units a year. If annual profit is 1.5 million, the saving from a shared currency is 120,000 / 1,500,000 = 8% of profit. Hedging costs would be extra.

Worked example: one interest rate for different needs

The union rate is 3%. Member X has 5% inflation and Member Y has 1%. Real interest rates: X is 1.03 / 1.05 − 1 = −1.9%. Y is 1.03 / 1.01 − 1 = +2.0%. X faces a negative real rate that can fuel borrowing and a boom. Y faces a positive real rate that restrains an economy needing stimulus. One rate is too loose for one and too tight for the other.

Worked example: no exchange rate to adjust

Suppose X’s costs rise 10% relative to its partners. Outside a union, a depreciation of 1 / 1.10 − 1 = −9.1% would offset it. Inside the union it cannot depreciate, so costs and wages must fall (an internal devaluation), which is slow, may need high unemployment and can deepen a recession.

Evaluation points that earn credit

• Say who gains. Exporters, importers, savers, borrowers and workers gain or lose differently.
• Use the time frame. Transaction savings come at once; the loss of adjustment shows up in a downturn.
• Link to elasticity, inflation, unemployment, growth and the current account.
• Test whether the economy is similar to its partners in its cycle, structure and flexibility of wages.
• Make a judgement. Choose, with a reason, which factor decides the outcome.

Common errors

• Writing “the currency is stronger so exports rise”. An appreciation makes exports dearer abroad.
• Mixing up depreciation (floating) with devaluation (fixed).
• Drawing the demand for a currency sloping upward.
• Treating a currency union as the same as a customs union. A customs union concerns trade barriers.
• Listing advantages and disadvantages without a judgement.

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).