Cambridge International AS and A Level Economics: Exchange rate systems, Marshall-Lerner and J curve (9708)

This guide covers 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, so it is not examined at AS. The syllabus says AS Level content is assumed knowledge for A Level Paper 3 and Paper 4.

All countries, currencies and figures are invented for illustration and are not real statistics. Country M uses the mira and Country N uses the nol. Floating rates, depreciation and appreciation are AS content, covered in the floating exchange rates guide. Read that first if the demand and supply diagram for a currency is unfamiliar.

Related pages: the Cambridge A Level Economics hub, the printable checklist, the revision notes, the practice set, the current account guide and the free 10-minute diagnostics.

What this unit covers

Outcome	Skill tested
11.2.1	Distinguish nominal from real exchange rates; explain trade-weighted exchange rates
11.2.2	Explain how the rate is determined under fixed and managed systems
11.2.3	Distinguish revaluation from devaluation of a fixed rate
11.2.4	Explain changes in the rate under different systems
11.2.5	Analyse the effects of rate changes on the external economy using Marshall-Lerner and the J curve

11.2.1 Measuring exchange rates

Nominal and real rates

The nominal exchange rate is the market-quoted value of one currency measured in another. The real exchange rate adjusts the nominal rate for differences in price levels between the two economies. It shows what a currency buys in goods, not just in money.

One way to express it, quoting nols per mira:

real rate = nominal rate × (price index in Country M ÷ price index in Country N)

The syllabus asks for the distinction, not a formula, so say clearly what you are doing. A rising real rate means Country M’s goods have become dearer relative to Country N’s when measured in a common currency.

Worked example. Both price indices are 100 in year 1.

• Year 1: nominal 3.00 nols per mira. Real rate = 3.00 × 100 ÷ 100 = 3.00 (the base).
• Year 2: nominal 3.30. Country M’s index is 104 and Country N’s is 102.
• Nominal change = (3.30 − 3.00) ÷ 3.00 × 100 = +10.0%.
• Real rate = 3.30 × 104 ÷ 102 = 3.365. Real change = (3.365 ÷ 3.00 − 1) × 100 = +12.2%.

The real appreciation (12.2%) is bigger than the nominal one (10.0%) because prices rose faster in Country M. Its exporters lose competitiveness twice: their prices rise at home and the mira buys more nols.

A nominal rate can stay still while the real rate drifts. If the nominal rate stays at 3.00 but Country M’s prices rise 6% while Country N’s rise 2%, the real rate becomes 3.00 × 106 ÷ 102 = 3.12, a real appreciation of 3.9%.

Trade-weighted exchange rates

A bilateral rate compares two currencies. A trade-weighted exchange rate (an index) measures a currency against a basket of partners’ currencies, with each weighted by that partner’s share of the country’s trade. It shows the overall movement in competitiveness.

Worked example. Country M trades with Country N (50% of trade), Country P (30%) and Country Q (20%). Base year = 100. A year later the mira index is 110 against N, 95 against P and 120 against Q.

Trade-weighted index = 0.50 × 110 + 0.30 × 95 + 0.20 × 120 = 55 + 28.5 + 24 = 107.5

The mira has appreciated 7.5% on average, even though it fell 5% against P. Always check that weights sum to 1 (or 100%).

11.2.2 Determination under fixed and managed systems

In a floating system the market sets the rate. The other systems limit that.

• Fixed (pegged) rate: the government or central bank sets an official rate (a par value, sometimes with a narrow permitted band) and commits to defend it.
• Managed (managed float) rate: the rate is mainly set by market forces, but the central bank intervenes to smooth sharp moves or to steer the rate. There is no rigid commitment to one value.

To hold a rate away from the market equilibrium, the central bank can:

1. Buy or sell the currency using foreign exchange reserves.
2. Change interest rates, which changes the flow of short-term funds.
3. Use exchange controls or other restrictions on currency flows.

Worked example. Demand for miras is D = 400 − 100r and supply is S = 100r − 60, where r is nols per mira and quantities are in millions of miras.

• Free-market equilibrium: 400 − 100r = 100r − 60, so 200r = 460 and r = 2.30. Quantity = 170.
• The central bank pegs at 2.50, above equilibrium. At 2.50, D = 150 and S = 190. There is excess supply of 40.
• To stop the mira falling, the bank must buy 40 million miras. This costs 40 × 2.50 = 100 million nols of foreign exchange reserves.

If the peg is below equilibrium there is excess demand. The bank sells miras and builds up reserves.

Interest rates give the bank another route. Raising them attracts short-term funds, raises demand for the currency and eases the pressure, but at the cost of higher borrowing costs at home.

11.2.3 Revaluation and devaluation

• Devaluation: a deliberate cut in the official value of a fixed rate by the government or central bank.
• Revaluation: a deliberate rise in the official value of a fixed rate.

Depreciation and appreciation are different: they are market-driven changes in a floating rate. Use the word that matches the system in the question.

Worked example. The peg is 2.50 nols per mira. Country M devalues to 2.25.

• Change in the mira’s value = (2.25 − 2.50) ÷ 2.50 × 100 = −10%.
• A mira-priced export of 500 miras cost foreign buyers 500 × 2.50 = 1,250 nols. It now costs 500 × 2.25 = 1,125 nols, which is 10% cheaper.
• An import priced at 900 nols cost 900 ÷ 2.50 = 360 miras. It now costs 900 ÷ 2.25 = 400 miras, which is 11.1% dearer.

Why devalue? To make exports cheaper and imports dearer, expecting to switch spending towards home output (an expenditure-switching effect) and reduce a current account deficit, or when reserves cannot defend the old rate. The risks are higher import prices, loss of credibility and retaliation. A revaluation does the reverse and can be used to curb imported inflation or to correct a surplus.

11.2.4 Changes in the rate under different systems

Take the market above: D = 400 − 100r and S = 100r − 60. Demand for miras falls by 60 at every rate, so D′ = 340 − 100r.

System	What happens	Result
Floating	Rate adjusts: 340 − 100r = 100r − 60, so r = 2.00. Quantity 140.	Mira depreciates by (2.00 − 2.30) ÷ 2.30 = 13.0%
Fixed at 2.50	Rate unchanged. At 2.50, D′ = 90 and S = 190. Excess supply 100.	Bank buys 100 million miras, spending 250 million nols of reserves
Managed, bank holds the rate at no lower than 2.20	At 2.20, D′ = 120 and S = 160. Excess supply 40.	Bank buys 40 million miras, spending 88 million nols

The pattern: under floating, the price absorbs the shock. Under fixed, the reserves absorb it, until they run low. Under managed, the shock is shared.

What changes the rate (or the pressure on it) is the same under every system: trade flows, investment flows, interest rate differences, inflation differences and speculation. Under a fixed rate these show up as reserve changes or policy changes, and the official rate changes only by a decision to devalue or revalue.

Strengths and weaknesses:

	Fixed	Managed
Strengths	Certainty for traders; can discipline inflation	Absorbs some shocks; more room for domestic policy; fewer reserves needed
Weaknesses	Needs large reserves; interest rates serve the peg, not the domestic economy; vulnerable to speculation	Less certain; intervention can fail; rules can be unclear

11.2.5 The Marshall-Lerner condition and the J curve

Marshall-Lerner

The Marshall-Lerner condition says a depreciation or devaluation improves the trade balance (the balance of exports and imports of goods and services, starting from roughly balanced trade) if the two price elasticities of demand (for exports and for imports), added together, exceed 1. Use absolute values:

PEDx + PEDm > 1

Reasoning: a lower rate cuts export prices abroad (volume rises) and raises import prices at home (volume falls). Whether total spending on imports falls depends on elasticity. If demand is elastic enough, the volume gain outweighs the price effect.

Worked example. Country M starts with exports and imports both 1,000 miras. The mira depreciates by 10%. Assume export prices fall 10% abroad and import prices rise 10% at home. This is a simplification, and the rule holds exactly only for small changes.

Short run: PEDx = 0.3 and PEDm = 0.4. The sum is 0.7, below 1.

• Exports: volume +3%, so 1,000 × 1.03 = 1,030.
• Imports: price +10%, volume −4%, so 1,000 × 1.10 × 0.96 = 1,056.
• Balance = 1,030 − 1,056 = −26. The balance worsens.

Long run: PEDx = 1.1 and PEDm = 0.9. The sum is 2.0.

• Exports: 1,000 × 1.11 = 1,110.
• Imports: 1,000 × 1.10 × 0.91 = 1,001.
• Balance = +109. The balance improves.

The J curve

Elasticities are often low just after a rate change, because contracts are fixed, buyers are slow to switch and firms need time to find new suppliers. So the balance first worsens, then improves as elasticities rise. The path looks like a letter J.

Illustrative path (balance before the change = 0, imports cost 1,100 miras at the new prices):

Period	PEDx + PEDm	Exports	Imports	Balance
0 (just after)	0.0	1,000	1,100	−100
1	0.5	1,020	1,067	−47
2	0.7	1,030	1,056	−26
3	1.1	1,060	1,045	+15
4	1.8	1,100	1,012	+88
5	2.1	1,120	1,001	+119

The balance turns positive at about the point where the sum passes 1 (the exact crossing differs a little because a 10% price change is not small). That is the link between the two ideas. Describe the diagram in words: balance on the vertical axis, time on the horizontal axis, falling below zero first, then rising above it.

Evaluation

• Elasticities may stay low if exports are specialised or imports are necessities.
• Higher import prices feed into costs and inflation, which erodes the competitive gain (the real rate rises back).
• Spare capacity is needed for exports to rise; without it, prices rise instead.
• Trading partners may retaliate or may devalue as well.
• Exporters using imported inputs face higher costs.
• The condition covers goods and services only. It says nothing on the financial account.
• The time to the turning point is uncertain, so the policy may not deliver within the period that matters.

Finish with a judgement: pick the factor that matters most in the case you are given and say why.

Common errors

• Writing “appreciation” for a change in a fixed rate, or “devaluation” for a floating one.
• Saying Marshall-Lerner needs each elasticity above 1. It is the sum.
• Using the condition with signs rather than absolute values.
• Ignoring the J curve and saying the balance improves at once.
• Mixing up quoting direction (nols per mira or miras per nol).
• Calling a trade-weighted index a simple average.
• Assuming a peg can be held for ever whatever the reserves.

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.