Cambridge O Level Economics: Foreign exchange rates (2281) – Revision Notes

These notes condense section 6.3 (6.3.1 to 6.3.5, foreign exchange rates) of the Cambridge O Level Economics (2281) syllabus for examination in 2026, version 2, which has no tiers. For full explanations read the study guide, then try the practice set. The countries, currencies and numbers here are fictional teaching examples. Related pages: the price elasticity of demand revision notes, the Cambridge O Level Economics hub, the printable checklist and the free diagnostics to find your weak spots.

Terms to know (6.3.1)

Word	Definition
Foreign exchange rate	How many units of one currency are swapped for one unit of another
Appreciation	A rise in the value of a currency (floating system)
Depreciation	A fall in the value of a currency (floating system)
Revaluation / devaluation	A deliberate rise / fall in a fixed rate set by the authorities
Floating system	Rate left to move with buying and selling of the currency
Fixed system	Rate set by the government or central bank, which acts to hold it
Speculation	Buying or selling a currency to profit from expected changes in its rate

Conversion and percentage change

Country G uses the gil and Country H uses the hos. Quote: 1 gil = 4.00 hos.

Method:

1. Identify which currency is “1” in the quote (the gil).
2. From gil to hos, multiply by 4.00. From hos to gil, divide by 4.00.
3. For a percentage change in the rate, use (new − old) ÷ old × 100.
4. For the other currency, invert the rate first, then repeat step 3.

Worked reminders:

• 36 gil × 4.00 = 144 hos. 220 hos ÷ 4.00 = 55 gil. 1 hos = 0.25 gil.
• Rate rises from 4.00 to 4.40: the gil appreciates by 0.40 ÷ 4.00 × 100 = 10%. The hos was worth 0.25 gil and is now worth 1 ÷ 4.40 = 0.2273 gil, a fall of 9.1%.

Determination of the rate (6.3.2)

Axes: vertical = price of the currency (hos per gil); horizontal = quantity of gil traded. Demand is a falling line and supply is a rising line. The equilibrium is where they cross.

	Demand for gil	Supply of gil
Comes from	Foreign buyers of Country G’s exports, tourists visiting, inward investment	Country G’s importers, tourists going abroad, outward investment
Shape reason	A higher rate makes exports dearer abroad, so fewer are bought	A higher rate makes imports cheaper, so more are bought

Disequilibrium: above equilibrium there is a surplus of the currency and the rate falls. Below equilibrium there is a shortage and the rate rises.

Causes of fluctuations (6.3.3)

Event	What happens to demand or supply of gil	Result for the gil
Foreign demand for exports grows	Demand shifts right	Appreciates
Residents buy more imports	Supply shifts right	Depreciates
Interest rate in Country G goes up	Demand rises and supply falls	Appreciates
Interest rate in Country G goes down	Demand falls and supply rises	Depreciates
Speculators think the gil will gain value	They buy now: demand shifts right	Appreciates
Speculators think the gil will lose value	They sell now: supply shifts right	Depreciates
An MNC sets up in Country G	It buys gil for local costs: demand shifts right	Appreciates
An MNC leaves or sends profits home	It sells gil: supply shifts right	Depreciates

Chain of reasoning for any cause: event → who needs to buy or sell gil → which curve shifts and which way → new equilibrium rate → appreciation or depreciation.

Worked reminder (speculation). A trader converts 600,000 hos into gil at 4.00 and gets 600,000 ÷ 4.00 = 150,000 gil. The rate rises to 4.50. Selling 150,000 gil gives 150,000 × 4.50 = 675,000 hos. Profit = 75,000 hos (12.5%).

Consequences for trade (6.3.4)

Export prices in foreign currency rise after an appreciation and fall after a depreciation. Import prices in home currency fall after an appreciation and rise after a depreciation.

Method for spending:

1. Find the new price after the rate change.
2. Find the percentage price change.
3. Quantity change = PED × percentage price change.
4. New spending = new price × new quantity. Compare with the old.

Worked reminder (exports, appreciation from 4.00 to 4.40). A crate costs 50 gil, so 200 hos abroad, and rises to 220 hos. Foreign buyers take 1,000 crates and spend 200,000 hos.

PED	New quantity	New spending	Change
−1.2 (elastic)	880	193,600	falls 3.2%
−0.6 (inelastic)	940	206,800	rises 3.4%

Worked reminder (imports, depreciation from 4.00 to 3.20). A good costs 120 hos. In gil the price is 30 at 4.00 and 120 ÷ 3.20 = 37.50 at 3.20, a rise of 25%. Country G buys 800 units, spending 24,000 gil.

PED	New quantity	New spending	Change
−0.3	740	27,750	rises 15.6%
−1.6	480	18,000	falls 25%

Rule: elastic demand means spending moves opposite to price; inelastic demand means spending moves with price. A depreciation improves the trade position only when demand for exports and for imports responds strongly to price, and the response grows over a longer period.

Floating versus fixed (6.3.5)

Defending a fixed rate. Suppose Country G fixes 1 gil = 4.00 hos and demand exceeds supply by 20 million gil at that rate. The central bank sells 20 million gil and receives 20 × 4.00 = 80 million hos, adding to reserves. If the gap went the other way, it would buy gil with reserves, and a limited stock of reserves would run down.

	Floating	Fixed
For	Automatic adjustment; few reserves needed; interest rates free for domestic use; falling rate helps exporters	Certainty for trade and investment; discipline on inflation; less speculation if credible
Against	Uncertainty; swings can deter trade; depreciation raises import prices	Needs reserves; interest rates tied to the peg; rate may be wrong and hard to change

Must-know distinctions:

• Appreciation (market-driven) is not revaluation (chosen by the authorities).
• A stronger currency makes exports dearer abroad but imports cheaper at home.
• Demand for a currency is not the same as demand for the country’s goods, though the second creates the first.

Evaluation reminders

Analysis explains what happens. Evaluation says how far, for whom and for how long. Useful prompts for this unit:

• Size of PED. An appreciation raises export prices, but spending on exports falls only if demand is elastic. Check the figure given.
• Time. PED is usually higher over a longer period, so the effect of a rate change builds up.
• Who gains and who loses. A depreciation helps exporters and firms competing with imports, but hurts importers, households buying foreign goods and firms using imported materials.
• Size of the cause. A one-point rise in the interest rate matters less if other countries are also raising theirs.
• Expectations. Speculation can move a rate more than trade flows do, and can reverse quickly.
• Country context. Fixed rates fit a small, open economy with large reserves. Floating rates fit an economy that wants freedom over its interest rates.

A short judgement sentence is stronger than a long list: “On balance, a depreciation is likely to help Country G’s exporters if their goods have elastic demand abroad, but the benefit is smaller if they import most of their materials.”

Quick self-test

1. What is meant by a foreign exchange rate?
2. At 1 gil = 4.00 hos, how many gil buy a 500-hos item?
3. The rate moves from 5.00 to 4.00 hos per gil. Calculate the percentage change in the gil.
4. Name two causes of an appreciation.
5. Which curve shifts, and which way, when MNCs leave Country G?
6. What does a depreciation do to export prices in foreign currency?
7. When does a depreciation raise the import bill?
8. Give one advantage and one disadvantage of a floating rate.
9. Give one advantage and one disadvantage of a fixed rate.
10. A depreciation of 20% raises import prices 25% and PED is −1.6. What happens to import spending?

Answers

1. How many units of one currency are swapped for one unit of another.
2. 500 ÷ 4.00 = 125 gil.
3. (4.00 − 5.00) ÷ 5.00 × 100 = −20%, a depreciation.
4. Any two: higher export demand, higher interest rates, speculation that it will rise, an MNC entering.
5. Supply shifts right as MNCs sell gil, so the gil depreciates.
6. They fall.
7. When demand for imports is inelastic, because quantity bought drops by less, in percentage terms, than the price climbs.
8. For: automatic adjustment. Against: uncertainty for traders.
9. For: price certainty. Against: reserves are needed to hold the rate.
10. Quantity falls 1.6 × 25 = 40%, so spending changes by 1.25 × 0.60 − 1 = −25%: it falls.

Where marks are usually lost

• Multiplying when the question needs dividing, or the reverse.
• Giving a percentage change for the wrong currency.
• Describing the effect on a country’s goods without saying how the currency is demanded or supplied.
• Shifting the wrong curve, for example moving demand when imports rise.
• Stating a depreciation improves trade without referring to PED.
• Forgetting to compare spending with the starting level.
• Listing floating and fixed points without a judgement for the country given.
• Using “weaker currency” and “lower rate of interest” as if they were the same.

Official syllabus

These notes follow the Cambridge O Level Economics (2281) syllabus for examination in 2026, version 2, published by Cambridge University Press & Assessment: section 6.3 Foreign exchange rates.