Cambridge A Level Economics: Exchange rate systems, Marshall-Lerner and J curve (9708) – Revision Notes

Condensed notes for syllabus section 11.2 (Exchange rates), outcomes 11.2.1 to 11.2.5, in the Cambridge International AS and A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. This is A Level content (topic 11), not examined at AS.

For full explanations, read the study guide. Then try the practice set, tick off the checklist, see the course hub, revisit the AS floating exchange rates notes and take a free 10-minute diagnostic.

All currencies and figures are invented for illustration. Country M uses the mira and Country N uses the nol.

Definitions

Term	Meaning
Nominal exchange rate	Price of one currency in terms of another, as quoted
Real exchange rate	Nominal rate adjusted for relative price levels; shows what a currency buys in goods
Trade-weighted exchange rate	Index of a currency against a basket of partner currencies, weighted by trade shares
Fixed (pegged) rate	Official rate set by the government or central bank and defended
Managed rate	Mainly market-determined, with central bank intervention to smooth or steer it
Devaluation	Deliberate cut in the official value of a fixed rate
Revaluation	Deliberate rise in the official value of a fixed rate
Marshall-Lerner condition	A fall in the rate improves the trade balance if PEDx + PEDm > 1
J curve	Balance worsens first after a fall in the rate, then improves

Formulas

Item	Formula
Percentage change	(new − old) ÷ old × 100
Real rate (nols per mira)	Nominal × price index of M ÷ price index of N
Trade-weighted index	Sum of (weight × bilateral index); weights sum to 1
Marshall-Lerner	PEDx + PEDm > 1, using absolute values
Reserves used to defend a peg	Excess supply of currency × the pegged rate

Method boxes

Real rate and trade-weighted index

1. Write both price indices and the nominal rate for each year.
2. Real rate = nominal × (home index ÷ foreign index).
3. Compare years by percentage change or as an index.
4. For a trade-weighted index, multiply each bilateral index by its weight, then add.
5. Check the weights add to 100%.

Worked reminder. Nominal rate rises from 2.50 to 2.60 nols per mira (+4.0%). Country M’s index goes from 100 to 101 and Country N’s from 100 to 104. Real rate = 2.60 × 101 ÷ 104 = 2.525. Against 2.50 that is +1.0%. The nominal rise overstates the real rise because Country N’s prices rose faster.

Trade-weighted reminder. Weights 60% and 40%, indices 105 and 95: 0.60 × 105 + 0.40 × 95 = 63 + 38 = 101.

Defending a peg

1. Find the equilibrium rate by setting demand equal to supply.
2. At the peg, compute demand and supply.
3. Excess supply: the bank buys the currency using reserves. Excess demand: it sells the currency and reserves rise.
4. Cost in foreign currency = quantity bought × pegged rate.

Worked reminder. D = 400 − 100r and S = 100r − 60. Equilibrium is r = 2.30. At a peg of 2.50, D = 150 and S = 190, excess supply 40. Cost = 40 × 2.50 = 100 million nols.

Marshall-Lerner and J curve

1. Add the two elasticities as positive numbers.
2. Above 1: the balance improves. Below 1: it worsens. Equal to 1: roughly unchanged.
3. Short run elasticities are low, so the sum starts below 1 (worsening).
4. As the sum rises above 1, the balance turns positive.

Systems at a glance

Feature	Fixed	Managed	Floating
Who sets the rate	Government or central bank	Market, with intervention	Market
Demand shock absorbed by	Reserves, interest rates	Price and reserves	Price
Reserves needed	Large	Moderate	Small
Interest rates	Serve the peg	Some room	Free for domestic aims
Certainty for traders	High	Medium	Low
Risk	Speculative attack, reserve loss	Intervention fails	Volatility

Changes in the rate under each system, using demand D′ = 340 − 100r after a fall in demand:

• Floating: r moves from 2.30 to 2.00, a depreciation of 13.0%.
• Fixed at 2.50: rate unchanged, excess supply 100, reserves used 250 million nols.
• Managed with a floor of 2.20: excess supply 40, reserves used 88 million nols.

Must-know distinctions

• Depreciation and appreciation: floating, market-driven. Devaluation and revaluation: fixed, a policy decision.
• Nominal and real: money terms against goods terms.
• Bilateral and trade-weighted: one partner against all partners.
• Fixed and managed: a commitment to a value against a discretion to intervene.
• Marshall-Lerner and the J curve: the first is the long-run condition, the second is the path over time.
• Each elasticity above 1 is not needed; the sum above 1 is.

Chain of reasoning: devaluation and the external economy

1. The official rate falls, so export prices fall abroad and import prices rise at home.
2. Short run: volumes barely move, so import spending rises and the balance worsens (J curve).
3. Over time, if PEDx + PEDm > 1, export volumes rise and import volumes fall.
4. Net exports rise, which raises aggregate demand and, with spare capacity, output and employment.
5. Evaluation: pass-through to inflation, imported inputs, spare capacity, retaliation, time lag, reserves and credibility.

J curve worked reminder

Country M’s exports and imports are both 1,000 miras. The mira falls 10%, so import prices rise 10% at home and export prices fall 10% abroad. Balance = exports − imports.

Period	PEDx + PEDm	Exports	Imports	Balance
0	0.0	1,000	1,100	−100
2	0.7	1,030	1,056	−26
3	1.1	1,060	1,045	+15
5	2.1	1,120	1,001	+119

Describe the shape in words: balance on the vertical axis, time on the horizontal axis. The curve dips below zero, reaches a low point, crosses zero at about the point where the sum passes 1, then rises. The figures use a simple model and hold exactly only for small changes.

Evaluation prompts

• How large are the elasticities, and how fast do they rise?
• Is there spare capacity for export growth?
• How much of the import price rise passes into inflation?
• Do exporters rely on imported inputs?
• Will partners retaliate?
• Can the central bank defend the rate, and is the policy credible?
• Which factor matters most here, and why?

Quick self-test

1. Country M’s currency is 3.30 nols per mira. Convert 1,980 nols into miras.
2. Nominal rate rises 10%; Country M’s prices rise faster than Country N’s. Does the real rate rise by more or less than 10%?
3. Calculate the trade-weighted index: weights 70% and 30%, bilateral indices 108 and 90.
4. A government cuts its official fixed rate. Is this devaluation or depreciation?
5. At a peg there is excess supply of 50 million miras at 2.40 nols per mira. How many nols of reserves are needed?
6. State the Marshall-Lerner condition.
7. PEDx is 0.9 and PEDm is 0.6. Will a devaluation improve the trade balance?
8. PEDx is 0.35 and PEDm is 0.5. What happens to the balance?
9. Why does the balance often worsen straight after a depreciation?
10. Give one reason a fixed rate may be abandoned.
11. Give one advantage of a managed rate over a fixed rate.
12. Name one reason a devaluation might not improve the current account even if the sum is above 1.

Answers

1. 1,980 ÷ 3.30 = 600 miras.
2. By more than 10%. Real = nominal × home index ÷ foreign index, and the home index is rising faster, so the price ratio is above 1.
3. 0.70 × 108 + 0.30 × 90 = 75.6 + 27 = 102.6.
4. Devaluation.
5. 50 × 2.40 = 120 million nols.
6. A fall in the rate improves the trade balance if PEDx and PEDm, taken together as a sum, exceed 1.
7. Yes. 0.9 + 0.6 = 1.5, which is above 1.
8. It worsens. 0.35 + 0.5 = 0.85, which is below 1.
9. Contracts, habits and slow switching keep volumes almost unchanged, while import prices rise at once.
10. Reserves run out under speculative pressure, or the peg conflicts with domestic policy goals.
11. More room for domestic policy and a smaller need for reserves, because the market absorbs part of any shock.
12. Rising import prices raise inflation and erode the competitive gain; other causes include no spare capacity and retaliation.

Where marks are usually lost

• Mixing devaluation with depreciation, or revaluation with appreciation.
• Quoting the rate the wrong way round.
• Using real-rate formulas with the price indices inverted.
• Forgetting that trade weights must sum to 1.
• Writing that each elasticity must exceed 1.
• Leaving out the short-run effect and stating that the balance improves at once.
• Describing a diagram with unnamed axes or no equilibrium point.
• Listing evaluation points without saying why one matters most.
• Stating a currency effect with no chain to output, prices or employment.

Official syllabus

Cambridge International AS & A Level Economics 9708, syllabus for examination in 2026, 2027 and 2028, published by Cambridge University Press & Assessment (Cambridge International), section 11.2 Exchange rates.