Pearson Edexcel International Advanced Level Economics: Exchange rates and their effects (YEC11)

This guide follows the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. It covers 4.3.3 item 2, points a to g: exchange rate systems, intervention, causes of change, the effects of a change and competitive depreciations. In the specification, Units 1 and 2 are IAS units, while Units 3 and 4 hold the extra IA2 content needed for the full IAL. This material sits in Unit 4, Developments in the global economy, so it is IA2 content. Every figure below is invented for illustration. Country A uses the ark and Country B uses the bel.

Related pages: revision notes, practice questions, exam preparation, the course hub, the checklist and the free diagnostics.

Scope and outcomes

Spec point	Skill
4.3.3 2a	Distinguish fixed, managed and floating rates
4.3.3 2b	Explain intervention: foreign currency transactions, interest rates, quantitative easing (QE)
4.3.3 2c	Explain the factors that move a floating rate
4.3.3 2d, 2e	Distinguish revaluation from appreciation, devaluation from depreciation
4.3.3 2f	Analyse effects on the current account (Marshall-Lerner, J-curve), capital and financial accounts, growth, employment, inflation, FDI
4.3.3 2g	Analyse competitive depreciations and devaluations

1. Fixed, managed and floating rates (2a)

An exchange rate states how much of one currency buys a unit of another. This page quotes it as bels per ark, so a higher figure means a stronger ark.

System	Who sets the rate	Main features
Fixed	The government or central bank announces a rate and defends it	Certainty for traders; needs reserves; interest rates are tied to the peg
Floating	Market demand and supply for the currency	Moves freely; no reserves needed; can be volatile
Managed	Market forces, but the authorities intervene to limit or steer movements	A compromise: some flexibility, some stability

A fixed system may allow a narrow band around the announced rate. In a managed system the target may be unannounced.

2. Intervention (2b)

Foreign currency transactions

The central bank buys or sells its own currency using its reserves of foreign currency. To raise the rate it buys its currency (demand shifts right). To lower it, it sells its currency and builds reserves.

Worked example. Country A pegs at 2.40 bels per ark. In the market, demand for arks is Qd = 160 − 50R and supply is Qs = 20 + 20R, where R is bels per ark and quantities are in billions of arks.

Equilibrium: 160 − 50R = 20 + 20R  →  140 = 70R  →  R = 2.00, Q = 60
At the peg R = 2.40:  Qd = 160 − 120 = 40,  Qs = 20 + 48 = 68
Excess supply of arks = 68 − 40 = 28 billion arks
Bels needed = 28 × 2.40 = 67.2 billion bels from reserves

The peg is above the equilibrium, so the ark is overvalued. The central bank must keep buying 28 billion arks every period. Reserves are finite, so the peg cannot be defended for ever.

Interest rates

A higher interest rate raises the return on holding the currency, attracting funds and shifting demand right. In the example, demand would have to become Qd = 188 − 50R to clear the market at 2.40 (check: 188 − 120 = 68). The cost is slower growth: higher rates reduce consumption and investment. Using interest rates for the exchange rate also means they cannot be set for domestic aims such as inflation or unemployment.

Quantitative easing

QE is the central bank creating money to buy financial assets, usually government bonds. Its main aim is to cut longer-term interest rates and raise lending and spending. It also tends to lower the exchange rate: lower yields reduce the return on the currency, funds flow out, and expectations of higher inflation weaken confidence.

3. Factors influencing a floating rate (2c)

A rate rises when demand for the currency rises (foreign buyers of exports, investors buying assets) or supply falls. It falls in the opposite cases.

Factor	Chain of reasoning	Rate
Relative interest rates	Higher rate than abroad → more deposits and bond purchases → demand for currency rises	Up
Relative inflation	Lower inflation than abroad → exports more competitive, imports less attractive	Up over time
Current account	A deficit means more currency supplied to buy imports than demanded for exports	Down (surplus: up)
Strength of the economy	Strong growth and good prospects attract investment, though faster growth also raises imports	Usually up
Capital flight	Loss of confidence → residents and foreigners sell the currency and move funds abroad	Down
Expectations and speculation	Expected rise → buying now, which causes the rise	Self-fulfilling
Global factors	A fall in a commodity price cuts export earnings of a commodity exporter → demand for its currency falls	Down

Purchasing power parity (PPP) theory

Absolute PPP says the exchange rate should equal the ratio of price levels, so the same basket costs the same in both countries when measured in one currency. Relative PPP says the currency of the higher-inflation country should depreciate by about the inflation gap.

Worked example 1 (absolute). A basket costs 120 arks in Country A and 300 bels in Country B. The PPP rate is 300 ÷ 120 = 2.50 bels per ark. The market rate is 2.00, so the ark is undervalued by (2.00 ÷ 2.50 − 1) × 100 = 20%.

Worked example 2 (relative). Inflation is 2% in A and 6% in B. The ark should rise by (1.06 ÷ 1.02) − 1 = 3.92%. From 2.00 the expected rate is 2.00 × 1.0392 = 2.078 bels per ark.

PPP is a long-run guide. Trade costs, capital flows and speculation let rates differ from it for years.

Interest rates and speculation

Worked example 3. A resident of Country B has 100,000 bels. Deposits earn 5% in A and 2% in B. At 2.00 bels per ark she buys 50,000 arks, which become 52,500 arks after a year. If the rate falls to 1.95, she gets 52,500 × 1.95 = 102,375 bels, against 102,000 by staying home. The higher interest rate wins by 375 bels. If the rate falls to 1.90, she gets 99,750 bels and loses 2,250 relative to staying. The break-even end rate is 102,000 ÷ 52,500 = 1.943. Investors weigh expected exchange rate movements as well as interest differentials, so expectations can reverse a flow.

4. Revaluation, appreciation, devaluation, depreciation (2d, 2e)

Term	Meaning	System
Appreciation	Market-driven rise in the value of a currency	Floating (or within a band)
Revaluation	Deliberate official rise in the fixed or target rate	Fixed or managed
Depreciation	Market-driven fall in the value of a currency	Floating (or within a band)
Devaluation	Deliberate official fall in the fixed or target rate	Fixed or managed

Percentages are not symmetrical. If the ark rises from 2.00 to 2.50 bels, the ark has appreciated by 25%. The bel in arks moves from 0.50 to 0.40, a depreciation of 20%. A good priced at 400 arks costs 800 bels before and 1,000 bels after, a rise of 25% for Country B’s buyers.

5. Effects of an exchange rate change (2f)

Suppose the ark depreciates from 2.00 to 1.60 bels, a fall of 20%. Foreign buyers pay 20% less for exports priced in arks. Import prices in arks rise by 2.00 ÷ 1.60 − 1 = 25%.

The current account, Marshall-Lerner and the J-curve

The Marshall-Lerner condition: a depreciation helps the current account only when PED for exports plus PED for imports exceeds 1. Below 1 the balance gets worse.

Worked example. Start with exports and imports both 500 million arks. Exports are 100 units at 5 arks. Imports are 100 units at 5 arks, rising to 6.25 arks after the depreciation. Export prices in arks are unchanged.

Short run: PED exports 0.4, imports 0.3 (sum 0.7)
  Export volume +20% × 0.4 = +8%  →  108 units × 5     = 540.0
  Import volume −25% × 0.3 = −7.5% →  92.5 units × 6.25 = 578.1
  Balance = 540.0 − 578.1 = −38.1 (worse)
Long run: PED exports 1.1, imports 0.7 (sum 1.8)
  Export volume +22% → 122 × 5 = 610.0
  Import volume −17.5% → 82.5 × 6.25 = 515.6
  Balance = +94.4 (better)

The J-curve is the path this follows over time. Contracts are fixed, buyers are slow to switch and demand is inelastic in the short run, so the deficit deepens at first and then narrows as elasticities rise. An illustrative path, in millions of arks: 0 at the start, −38 after three months, −25 after six, +10 after nine, +50 after twelve, +94 after eighteen.

Capital and financial accounts

Cheaper domestic assets attract inward investment, but expected further falls encourage outflows. The net effect depends on expectations more than the level of the rate.

Growth and employment

If net exports rise by 40 million arks, the withdrawal rate (MPW) is 0.5, and there is spare capacity, the multiplier is 1 ÷ 0.5 = 2 and GDP rises by 80 million. On GDP of 2,000 million that is 4%. At 0.04 million arks of output per worker, about 2,000 jobs are needed. The extra output and jobs would reduce unemployment, mainly cyclical unemployment, though workers laid off in import-competing firms may stay unemployed if their skills do not fit the new jobs. Evaluation:

• With no spare capacity, extra demand raises prices rather than output.
• Imported inputs cost more, which may offset some of the gain.
• Jobs depend on labour intensity in export and import-competing industries.
• Time lags matter, as the J-curve shows.

Inflation

Imports are 20% of the consumer basket. A 25% rise in import prices raises the price level directly by 0.20 × 25 = 5.0%. If only 60% is passed on to consumers, the rise is 3.0%. Further effects: dearer imported inputs raise costs (cost-push), higher demand pulls up prices, and workers may seek higher wages.

FDI

A factory priced at 600 million arks costs a Country B firm 1,200 million bels at 2.00, but only 960 million at 1.60: 20% cheaper. A depreciation therefore lowers the foreign-currency cost of entry. Against that, profits of 50 million arks are worth 100 million bels before and 80 million after, so the return in the investor’s currency falls. Stability, market size, skills and infrastructure often matter more.

6. Competitive depreciations (2g)

A competitive depreciation or devaluation is a deliberate lowering of the rate to gain price competitiveness, sometimes called beggar-thy-neighbour. The first mover gains exports. Trading partners lose market share and may retaliate.

	B keeps its rate	B devalues too
A keeps its rate	No change	A loses competitiveness
A devalues	A gains, B loses	Gains cancel; both face dearer imports

Consequences:

1. Gains disappear if others follow, leaving inflation and volatility.
2. Dearer imports lower real incomes and raise costs.
3. Uncertainty discourages trade and investment, and tariffs may follow.
4. Pressure for supply-side reform falls, so productivity may not improve.

Evaluating exchange rate changes

Judgement points for essays:

• Elasticities and the time period decide the current account result.
• Spare capacity decides whether growth or inflation follows.
• Import content of exports and pass-through limit the gain.
• A strong rate cuts inflation and helps importers, but hurts exporters.
• Which groups gain or lose, and how other countries respond.

Common errors

• Calling a market fall a devaluation, or an official change a depreciation.
• Treating a 20% fall in one currency as a 20% rise in the other.
• Using Marshall-Lerner without the time lag, or testing one elasticity instead of the sum.
• Stating that a depreciation always improves growth.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, first teaching September 2018, published by Pearson Education Limited. Section 4.3.3, item 2, points a to g.