Cambridge O Level Economics: Foreign exchange rates (2281)

This guide covers 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. The countries, currencies and numbers below are fictional teaching examples, not real data. Condensed recall is in the revision notes and exam-style questions are in the practice set. Elasticity is taught in the price elasticity of demand guide and market equilibrium in the supply and equilibrium guide. See also the Cambridge O Level Economics hub, the printable checklist and the free diagnostics.

Coverage map

Section	Skill to show
6.3.1	Define a foreign exchange rate; know floating and fixed systems
6.3.2	Show how the demand and supply of a currency produce the equilibrium rate
6.3.3	Explain why rates move: changes in trade demand, interest rates, speculation, MNCs arriving or leaving
6.3.4	Show how rate changes alter export and import prices and spending, using PED
6.3.5	Contrast floating and fixed systems and weigh their strengths and weaknesses

6.3.1 What a foreign exchange rate is

A foreign exchange rate shows how many units of one currency are swapped for one unit of another. In effect it is the price of a currency. Country B uses the brin and Country S uses the sarn. Suppose 1 brin = 3.00 sarn. The same fact can be turned round: 1 sarn = 1 ÷ 3.00 = 0.33 brin.

Worked example 1. At 1 brin = 3.00 sarn:

• A coat costs 450 sarn in Country S. A buyer in Country B pays 450 ÷ 3.00 = 150 brin.
• A tourist from Country B changes 80 brin and receives 80 × 3.00 = 240 sarn.

Quote the rate with the brin as the single unit. To convert brin into sarn, multiply by 3.00. To convert sarn into brin, divide by 3.00.

A rise in the value of a currency is an appreciation. A fall is a depreciation. If the rate moves from 3.00 to 3.60, the brin has appreciated by (3.60 − 3.00) ÷ 3.00 × 100 = 20%. The sarn has depreciated, but by less. One sarn was worth 0.3333 brin and is now worth 1 ÷ 3.60 = 0.2778 brin, a fall of (0.2778 − 0.3333) ÷ 0.3333 × 100 = 16.7%. Always say which currency you are measuring.

In a floating system, buyers and sellers in the foreign exchange market decide the rate. In a fixed system, the government or central bank picks the rate and steps in to defend it. Under a fixed system, an upward change that the authorities choose is a revaluation and a downward one is a devaluation.

6.3.2 How the rate is determined

The foreign exchange market is where currencies are bought and sold. Put the exchange rate (sarn per brin) on the vertical axis and the quantity of brin on the horizontal axis.

• Demand for brin comes from people who must buy brin to pay for something in Country B: foreign buyers of its exports, tourists, and foreigners investing there. The demand curve falls from left to right. At a higher rate Country B’s goods cost more in sarn, so fewer are bought.
• Supply of brin comes from people in Country B who sell brin to buy foreign currency: importers, tourists going abroad, and residents investing abroad. Supply slopes up. At a higher rate foreign goods are cheaper in brin, so more are bought.

Illustrative schedule (millions of brin per month):

Rate (sarn per brin)	2.0	2.5	3.0	3.5	4.0
Demand for brin	130	115	100	85	70
Supply of brin	70	85	100	115	130

Demand equals supply at 3.00 sarn per brin, with 100 million brin traded. That is the equilibrium rate. Check the disequilibrium on either side:

• At 3.5, supply is 115 and demand is 85. There is a surplus of 30 million brin. Sellers compete to get rid of them, so the price of the brin falls back towards 3.0.
• At 2.5, demand is 115 and supply is 85. There is a shortage of 30 million. Buyers bid the price up towards 3.0.

A sketch you can reproduce (D = demand, S = supply):

rate
 4.0 |  D                    S
 3.5 |      D            S
 3.0 |          D    S        <- cross at 3.0, quantity 100
 2.5 |      S        D
 2.0 |  S                D
     +----------------------------- brin per month

6.3.3 Causes of fluctuations

Any change that moves the demand or supply curve changes the equilibrium rate. Under a floating system the rate then moves; under a fixed system the pressure builds up instead.

Exports and imports. Foreign demand for Country B’s goods rises, adding 30 million to demand at every rate. The new demand is 160, 145, 130, 115, 100 at the five rates above. Supply is unchanged, so demand equals supply at 3.5 (115 each). The brin appreciates by (3.5 − 3.0) ÷ 3.0 × 100 = 16.7%. A rise in demand for imports does the opposite: residents sell more brin to buy foreign currency, supply shifts right by 30 million, and the equilibrium falls to 2.5, a 16.7% depreciation.

Interest rates. If Country B raises its interest rate, foreign savers can earn more by holding deposits there. They must buy brin first, so demand rises. Residents also keep more savings at home, so supply falls. The brin appreciates. A fall in the interest rate has the opposite effect.

Speculation. Speculators buy the currency they think will gain value and sell the one they think will lose it. They can make the expectation come true. Suppose a speculator holds 1,200,000 brin and expects the rate to fall from 3.00 to 2.50.

• Sell 1,200,000 brin at 3.00: 1,200,000 × 3.00 = 3,600,000 sarn.
• If the rate does fall to 2.50, buy brin back: 3,600,000 ÷ 2.50 = 1,440,000 brin.
• Profit: 1,440,000 − 1,200,000 = 240,000 brin, or 20%.

If many speculators act together, the extra supply of brin pushes the rate down, as they predicted.

MNCs. When a multinational company (MNC) sets up in Country B, it brings foreign currency and must buy brin to pay wages and local suppliers. Spending 45 million sarn on local costs needs 45 ÷ 3.00 = 15 million brin. Demand rises and the brin appreciates. When an MNC leaves, or sends profits home, it sells brin and buys foreign currency. Supply rises and the brin depreciates.

6.3.4 Consequences for export and import prices and spending

Take export prices first. Country B sells a bicycle for 600 brin. At 3.00 it costs a buyer in Country S 600 × 3.00 = 1,800 sarn. After the brin appreciates to 3.60, it costs 600 × 3.60 = 2,160 sarn, up 20%. An appreciation raises export prices in foreign currency. A depreciation lowers them.

Now import prices. A machine costs 900 sarn in Country S. At 3.00 it costs Country B 900 ÷ 3.00 = 300 brin. If the brin depreciates to 2.50, it costs 900 ÷ 2.50 = 360 brin, up 20%. A depreciation raises import prices in home currency. An appreciation lowers them.

What happens to spending depends on price elasticity of demand (PED). Spending = price × quantity, and the quantity change is the PED multiplied by the percentage price change.

Worked example 2 (exports after an appreciation). Foreign buyers take 2,000 bicycles a month at 1,800 sarn, so they spend 3,600,000 sarn. The price rises 20%.

PED	Quantity change	New quantity	New spending (2,160 sarn each)	Change in spending
−1.8 (elastic)	−36%	1,280	2,764,800	falls 23.2%
−0.6 (inelastic)	−12%	1,760	3,801,600	rises 5.6%

If demand is elastic, spending on the exports falls. If it is inelastic, spending rises. Note that exporters are paid in brin, and the brin price has not changed, so their brin revenue falls in both cases (by 36% and 12%). A strong currency hurts exporters whichever way spending moves, unless they cut their foreign price.

Worked example 3 (imports after a depreciation). Country B buys 500 machines a year at 300 brin, spending 150,000 brin. The price rises 20% to 360 brin.

PED	New quantity	New spending	Change
−0.5	450	162,000	rises 8%
−0.8	420	151,200	rises 0.8%
−1.5	350	126,000	falls 16%

A depreciation cuts spending on imports only if import demand is elastic. If imports are necessities with no substitutes, demand is inelastic and the import bill rises. PED is higher with substitutes, with more time to adjust, and for goods that take a large share of income.

Evaluation. Say which way the effect goes, then qualify it: how big is the PED, how long is the period, and do exporters pass the change into their prices? An exporter that relies on imported materials sees costs rise after a depreciation, which offsets some of the gain.

6.3.5 Floating and fixed systems compared

Under a fixed rate the central bank must keep the market rate at the chosen value. Suppose the rate is fixed at 3.00 and demand for brin falls by 30 million at every rate. At 3.00 demand is now 70 and supply is 100, a surplus of 30 million brin. To hold the rate the central bank can:

• buy the surplus brin using foreign currency reserves: 30 million × 3.00 = 90 million sarn;
• raise interest rates to attract foreign savers and raise demand;
• restrict spending on imports (a harsher option).

Reserves are limited. If the problem is permanent, the authorities may have to devalue. Left to float, the rate in this case would fall to 2.50.

	Floating	Fixed
Advantages	Adjusts on its own as demand and supply change; little need for big reserves; interest rates can aim at home goals; a falling rate helps exporters	Certainty about future prices helps trade and investment; limits speculation if credible; discipline on inflation
Disadvantages	Uncertainty and risk for traders; large swings can discourage trade and investment; a depreciation raises import prices	Needs reserves; interest rates are tied to defending the peg instead of the home economy; the rate can become wrong and cannot adjust easily; devaluation can shake confidence

Evaluation. A fixed rate can suit a country whose trade is concentrated with one partner and which values stable prices. It needs large reserves and a credible government. A floating rate suits an economy that wants control over its interest rates. Judge by the country’s situation.

Common errors

• Mixing up which currency is “1” in the quote, then multiplying instead of dividing.
• Treating a 20% appreciation of one currency as a 20% depreciation of the other.
• Writing that a depreciation always improves trade. It depends on PED.
• Saying “demand for exports” when you mean demand for the currency. The link is: foreign buyers must buy the currency first.
• Forgetting that a fixed rate still faces market pressure.

Official syllabus

This guide follows 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.