Cambridge IGCSE Economics: Foreign exchange rates (0455)

This guide teaches sections 6.3.1 to 6.3.5 of the Cambridge IGCSE Economics 0455 syllabus for examination in 2026: what a foreign exchange rate is, how demand and supply set it, why it changes, what a change does to prices and to spending on trade, and the case for floating and fixed systems. The syllabus is not tiered. Every country, currency and figure below is invented for practice and is not a real statistic.

Related pages: revision notes, practice questions, the Cambridge IGCSE Economics hub, the printable checklist and the free diagnostics. For elasticity calculations see the price elasticity guide, and for interest rates and exchange-rate policy see the monetary policy guide.

What you must be able to do

Section	Outcome
6.3.1	Define a foreign exchange rate; describe floating and fixed systems
6.3.2	Explain how demand for and supply of a currency determine the equilibrium rate
6.3.3	Explain causes of fluctuations: export and import demand, interest rates, speculation, MNCs entering or leaving
6.3.4	Explain effects on export and import prices and on spending on imports and exports, using PED
6.3.5	Explain the difference between, and the advantages and disadvantages of, floating and fixed systems

6.3.1 Definition, floating and fixed systems

A foreign exchange rate tells you how much of one currency buys a unit of another. Country L uses the lumo. Country D uses the dorn. Suppose 1 lumo = 0.50 dorn. The same rate can be turned round: 1 dorn = 1 ÷ 0.50 = 2 lumos.

Worked conversions at 1 lumo = 0.50 dorn:

• A visitor from Country L sees a meal priced at 840 dorn. Cost in lumos = 840 ÷ 0.50 = 1,680 lumos.
• A trader changes 2,000 lumos into dorn: 2,000 × 0.50 = 1,000 dorn.

Rule: to go from the currency whose price is quoted into the other, multiply. To go back, divide.

If the rate rises to 1 lumo = 0.60 dorn, the lumo has appreciated: it buys more dorn. The change is (0.60 ÷ 0.50 − 1) × 100 = 20%. The dorn has depreciated, but not by 20%. One dorn was worth 2 lumos and is now worth 1 ÷ 0.60 = 1.67 lumos, a fall of (1.67 ÷ 2 − 1) × 100 = −16.7%. Percentage changes in the two directions differ, so always say which currency you are measuring.

Floating system. The rate is set by demand and supply in the foreign exchange market. The government does not fix it, so it moves up and down.

Fixed system. The government or central bank sets a rate against another currency and acts to hold it there. It does this by buying or selling currency from its reserves of foreign currency, and by using interest rates. Under a fixed system the authorities can also decide to change the fixed rate itself.

6.3.2 Equilibrium in the foreign exchange market

Think of the market for lumos. On the vertical axis is the price of a lumo (dorn per lumo). On the horizontal axis is the quantity of lumos traded per week.

• Demand for lumos comes from foreign buyers who need lumos to pay for Country L’s exports, to visit, or to invest there. The curve slopes downward: at a higher price of the lumo, exports cost more dorn, so fewer are bought and fewer lumos are wanted.
• Supply of lumos comes from people in Country L who sell lumos to buy dorn, to pay for imports or to invest abroad. The curve slopes upward: at a higher price of the lumo, each lumo buys more dorn, so imports are cheaper and more are bought.

The equilibrium rate is where the curves cross. An invented schedule, in millions of lumos per week:

Rate (dorn per lumo)	Demand	Supply	Position
0.30	90	40	Shortage of 50
0.40	80	55	Shortage of 25
0.50	70	70	Equilibrium
0.60	60	85	Surplus of 25
0.70	50	100	Surplus of 50

At 0.60 there is a surplus of 85 − 60 = 25 million lumos. Sellers compete to offload them, so the rate falls. At 0.40 there is a shortage of 80 − 55 = 25. Buyers bid the price up, so the rate rises. Both movements end at 0.50, where 70 million lumos are traded.

Under a fixed system the same curves exist, but the rate does not move. Suppose the authorities fix 1 lumo = 0.50 dorn and demand rises by 25 million at each rate. At 0.50 demand is 95 and supply is 70, a shortage of 25. To hold the rate the central bank must sell 25 million lumos and take in dorn, or raise interest rates to attract more buyers.

6.3.3 Causes of fluctuations

Any cause works by shifting the demand curve or the supply curve for the currency. Name the curve, give the direction, then state the new rate.

Cause	Curve that shifts	Effect on the lumo
Higher foreign demand for Country L’s exports	Demand shifts right	Appreciates
Higher demand in Country L for imports	Supply shifts right	Depreciates
Higher interest rates in Country L	Demand right, supply left	Appreciates
Speculators expect the lumo to rise	Demand right	Appreciates
Speculators expect the lumo to fall	Supply right, demand left	Depreciates
An MNC enters and builds a plant	Demand right	Appreciates
An MNC leaves, selling up and sending funds home	Supply right	Depreciates

Worked example, demand shift. Using the schedule above, foreign demand for exports rises by 20 million lumos at every rate. The straight lines that fit the table are demand = 120 − 100 × rate and supply = −5 + 150 × rate. New demand is 140 − 100 × rate. Setting them equal: 145 = 250 × rate, so the rate is 0.58 and 82 million lumos are traded. The lumo has appreciated by (0.58 ÷ 0.50 − 1) × 100 = 16%.

Worked example, supply shift. Instead, households in Country L want 20 million more lumos’ worth of imports at each rate. Supply becomes 15 + 150 × rate. Setting demand equal to supply: 105 = 250 × rate, so the rate is 0.42 and 78 million are traded. The lumo has depreciated by (0.42 ÷ 0.50 − 1) × 100 = −16%.

Interest rates. If Country L raises its rate of interest from 3% to 6%, savers abroad can earn more by holding deposits in lumos. They must buy lumos first, so demand rises. Residents of Country L also keep more savings at home, so supply of lumos falls. The lumo appreciates. Evaluate: the effect depends on interest rates in other countries and on whether people expect the lumo to hold its value.

Speculation. Speculators buy a currency they expect to rise and sell one they expect to fall. Their actions can bring about the change they expect, so a rumour can move a rate.

MNCs. A multinational company entering Country L must buy lumos to pay wages, rent and suppliers, which raises demand. When it leaves, it sells assets and sends profits and capital abroad, which raises supply.

6.3.4 Consequences for prices and spending

Export and import prices

A lumo exporter sells a cake for 20 lumos. Foreign buyers pay in dorn.

Rate	Price paid in dorn	Change
0.50	20 × 0.50 = 10
0.60 (appreciation)	20 × 0.60 = 12	+20%
0.40 (depreciation)	20 × 0.40 = 8	−20%

A machine from Country D costs 15 dorn. Households in Country L pay in lumos.

Rate	Price paid in lumos	Change
0.50	15 ÷ 0.50 = 30
0.60 (appreciation)	15 ÷ 0.60 = 25	−16.7%
0.40 (depreciation)	15 ÷ 0.40 = 37.50	+25%

After an appreciation, foreign buyers pay more for the country’s exports while its own households pay less for imports. A depreciation has the opposite effect on both.

Spending, using PED

PED = % change in quantity demanded ÷ % change in price. So % change in quantity = PED × % change in price. This is an approximation for large changes. Spending is price × quantity, measured in the buyer’s currency.

Exports after an appreciation. The cake price abroad rises 20%, from 10 to 12 dorn. Foreign buyers take 5,000 cakes at the start, so their spending is 5,000 × 10 = 50,000 dorn.

• PED = −1.5 (elastic). Quantity falls 1.5 × 20 = 30%, to 3,500. Spending = 3,500 × 12 = 42,000 dorn. Spending on exports falls by 16%.
• PED = −0.5 (inelastic). Quantity falls 10%, to 4,500. Spending = 4,500 × 12 = 54,000 dorn. Spending rises by 8%.

Imports after a depreciation. The machine price in lumos rises 25%, from 30 to 37.50. Country L buys 200 machines at the start, so spending is 200 × 30 = 6,000 lumos.

• PED = −0.4 (inelastic). Quantity falls 10%, to 180. Spending = 180 × 37.50 = 6,750 lumos. Spending on imports rises.
• PED = −2 (elastic). Quantity falls 50%, to 100. Spending = 100 × 37.50 = 3,750 lumos. Spending on imports falls.

Summary: when price rises, spending falls if demand is elastic and rises if demand is inelastic. When price falls, the reverse holds. A depreciation helps a country’s trade position most when demand for its exports and for its imports is elastic. In the short run demand is often less elastic, because contracts and habits take time to change.

6.3.5 Floating versus fixed systems

	Floating	Fixed
Advantages	Rate adjusts automatically to demand and supply. No need to hold large reserves. Interest rates can be set for domestic aims.	Certainty for traders and investors. Can encourage trade and investment. Can keep inflation down by tying the currency to a stable one.
Disadvantages	Uncertainty and risk for traders. Rates can swing widely. Speculation can destabilise. A fall in the rate raises import prices.	Needs reserves to defend the rate. Interest rates may have to be set to protect the rate, not the economy. The rate may drift away from its market level.

Worked example, defending a peg. Country L fixes 1 lumo = 0.50 dorn. Suppose supply of lumos exceeds demand by 20 million per week at that rate. The central bank must buy 20 million lumos, paying 20 × 0.50 = 10 million dorn per week from its reserves. With 100 million dorn in reserves, it can keep this up for 100 ÷ 10 = 10 weeks. After that it must change the fixed rate or raise interest rates.

Evaluating. A floating system suits a large economy with strong institutions and a mixed pattern of trade. A fixed system may suit a small economy that trades mostly with one partner and wants stable prices, provided it holds enough reserves. Neither is best in every case.

Common errors

• Saying demand for the exporter’s currency falls when its exports rise. More exports mean more demand for that currency.
• Using one percentage for both currencies. A 20% rise in one currency is a 16.7% fall in the other.
• Showing a shift without naming the curve (demand or supply of which currency).
• Saying a depreciation always improves trade. The result depends on PED and on time.
• Confusing price paid with price received. Foreign buyers pay in their currency.

Official syllabus

Source: Cambridge IGCSE Economics 0455 syllabus for examination in 2026, version 2, Cambridge University Press & Assessment, section 6.3 Foreign exchange rates (6.3.1 to 6.3.5).