OCR A Level Economics: Exchange rate determination, measures and systems (H460) – Revision Notes

These notes condense the first part of the OCR A Level Economics (H460) topic Exchange rates (specification Version 3.0, June 2026, for first assessment in 2021), in the area of study The global context. Read the full study guide for the explanations, then test yourself on the practice questions. Use the OCR Economics hub, the printable checklist and the free diagnostics to find gaps. Purchasing power parity, the Marshall-Lerner condition and managing a rate for competitiveness are separate units. All figures here are invented.

Definitions to know

Term	Meaning
Exchange rate	Units of one currency needed to obtain one unit of another
Appreciation, depreciation	A rise or fall in a floating currency’s value
Revaluation, devaluation	Official upward or downward resetting of a pegged rate
Floating system	Market forces fix the rate
Fixed (pegged) system	Central bank commits to a target rate
Hybrid system	Mixes fixed and floating features
Bilateral rate	Between two currencies only
Effective rate (EER)	Trade-weighted index against many partners
Nominal rate	Market rate, not adjusted for prices
Real rate	Nominal rate adjusted for relative price levels
Foreign exchange reserves	Foreign currency held by the central bank for intervention

Determination in a floating system

• Axes: price of the home currency (in foreign currency) up the side, quantity of the home currency along the bottom.
• Demand slopes down. It comes from exports, inward investment, tourism and speculation on a rise.
• Supply slopes up. It comes from imports, outward investment and speculation on a fall.
• Rightward demand shift (or leftward supply shift) gives appreciation. The opposite gives depreciation.

Method in steps:

1. Label the axes with the currency pair.
2. Draw D and S and mark the equilibrium rate and quantity.
3. Say what shifts the curve and why.
4. Draw the new curve and mark the new equilibrium.
5. State the direction and size of the change.

Reminder. Demand = 900 − 1000p, supply = 100 + 1000p. Equilibrium is 900 − 1000p = 100 + 1000p, so p = 0.40 and Q = 500. If demand becomes 700 − 1000p, then p = 0.30 and Q = 400. The currency has depreciated by 25%.

Determination in a fixed system

• The central bank sets the peg and supplies or absorbs the gap between demand and supply at that rate.
• Excess demand for the currency: the bank sells its own currency and buys foreign currency, so reserves rise.
• Excess supply: the bank buys its own currency using reserves, so reserves fall.
• Reserves are finite. Other tools are higher interest rates, capital controls or a devaluation.

In steps: find Qd and Qs at the peg, take the difference, then multiply the quantity by the rate to find the reserve change.

Reminder. Peg at 0.40, demand = 700 − 1000p, supply = 100 + 1000p. At 0.40, Qd = 300 and Qs = 500, an excess supply of 200. The bank buys 200 units of its own currency, spending 200 × 0.40 = 80 units of foreign reserves. Without the peg the rate would settle at 0.30.

Measures

Measure	Use	Weakness
Bilateral	Simple, traders and tourists	Ignores other partners
Effective	Whole-economy view	Weights change over time
Nominal	Immediate price of a currency	Ignores relative inflation
Real	Whether goods are dear or cheap abroad	Needs price data and a base year

Effective rate by steps. Find each partner’s share of trade, multiply by its bilateral index, and add.

Reminder. Shares 0.6 and 0.4, indices 105 and 90: EER = 63 + 36 = 99, so the currency lost 1% overall though it rose against one partner.

Real rate by steps. Real rate = nominal rate (foreign per home) × home price level ÷ foreign price level. Convert to an index by dividing by the base-year value.

Reminder. Nominal index falls 100 to 96 while home prices rise 8% relative to partners: 96 × 1.08 = 103.7. The currency depreciated nominally yet appreciated in real terms.

Reading trend data

• State the direction, with figures.
• Calculate percentage changes: (new − old) ÷ old × 100.
• Identify turning points and the biggest swing.
• Compare nominal and real series.
• Suggest causes, then say which are temporary.
• Beware averages that hide volatility.

Reminder. An index runs 100, 106, 101, 95. The changes are +6.0%, −4.7% and −5.9%. From peak to end it fell (95 − 106) ÷ 106 = −10.4%. Say that a rise, a reversal and a decline occurred, then link each to a cause.

Causes of change

Cause	Direction of effect on the home currency
Higher relative interest rates	Rises (hot money inflow)
Higher relative inflation	Falls over time
Faster growth, rising imports	Falls in the short run; may rise if it attracts investment
Rising exports or inward investment	Rises
Loss of confidence, political shock	Falls
Central bank intervention	Moves towards its target
Commodity price rise (for an exporter)	Rises

Evaluate by magnitude, time lag, whether the change is expected to last, and whether other causes offset it. A rise in interest rates, for instance, may be outweighed by inflation or by fears about debt.

Consequences of change (depreciation; reverse for appreciation)

• Exports cheaper abroad, imports dearer. The effect on the trade balance depends on elasticities (Marshall-Lerner unit).
• Cost-push and imported inflation rise.
• Aggregate demand rises through net exports, but short-run aggregate supply falls as inputs cost more.
• Foreign-currency debts rise in home-currency terms.
• Firms and investors face uncertainty if rates are volatile.
• Living standards fall for consumers who buy imports or travel abroad, while foreign visitors find the country cheaper.
• Each effect varies with openness, spare capacity and how long the change lasts.

Reminder (the mora appreciates). Import price 40 nedo at 5.00 mora per nedo costs 200 mora. If the rate becomes 4.00 mora per nedo it costs 160 mora, down 20%. Home buyers of imports gain, but home exporters become less price-competitive.

Systems compared

System	Merits	Drawbacks
Floating	Self-adjusting; policy freedom; small reserves	Volatility; uncertainty
Fixed	Stability; inflation discipline	Large reserves; rate may be wrong; speculative attack; loses interest rate freedom
Hybrid	Compromise	Credibility; reserves; bands can be tested

Hybrid systems. Examples are a managed float, a band, a crawling peg and a basket link. For current examples, check the latest International Monetary Fund classification. Its 2023 report classes China as an “other managed arrangement” and Singapore as a “crawl-like arrangement”. A currency board such as Hong Kong’s is a hard peg.

In a managed float the bank smooths day-to-day moves but lets the trend follow the market. In a band system it steps in only at the limits. A crawling peg moves the target gradually, for example to offset a higher inflation rate than partners have.

Which system is best depends on openness, institutions, reserves, the type of shock and the inflation record. Always give a judgement.

Must-know distinctions

• Appreciation or depreciation (floating) versus revaluation or devaluation (fixed).
• Nominal versus real.
• Bilateral versus effective.
• Exchange rate versus the balance of payments: one is a price, the other a record of flows.
• Short-run causes (flows, expectations) versus long-run causes (relative prices).

Quick self-test

1. The rate moves from 5.00 to 4.00 mora per nedo. By what percentage has the nedo depreciated?
2. By what percentage has the mora appreciated in nedo terms?
3. Weights 0.6 and 0.4, bilateral indices 105 and 90. Calculate the EER.
4. A nominal index falls from 100 to 96 and relative prices rise 8%. What is the real index?
5. A central bank has reserves of 60 units and spends 12 a month. How long will reserves last?
6. Give two causes of a rightward shift in demand for a currency.
7. State one drawback of a fixed system.
8. State one merit of a floating system.
9. What is a crawling peg?
10. Explain why a depreciation can raise inflation.

Answers

1. (4 − 5) ÷ 5 = −20%. The nedo has depreciated by 20%.
2. 1 ÷ 5 = 0.20 nedo per mora, now 1 ÷ 4 = 0.25. The rise is (0.25 − 0.20) ÷ 0.20 = 25%.
3. (0.6 × 105) + (0.4 × 90) = 63 + 36 = 99.
4. 96 × 108 ÷ 100 = 103.68, or 103.7. A real appreciation.
5. 60 ÷ 12 = 5 months.
6. Any two: higher export demand, inward investment, higher relative interest rates, speculation on a rise.
7. Any one: reserves needed, interest rate freedom lost, rate may be misaligned, open to speculative attack.
8. Any one: automatic adjustment, interest rate freedom, no need for large reserves.
9. A target rate that the authorities adjust gradually by a set rule.
10. Imports and imported inputs cost more in home currency, raising costs and prices.

Where marks are usually lost

• Not saying which currency the price is quoted in, and so reversing the direction of change.
• Calculating a percentage change from the wrong base.
• A diagram with no labelled axes, no starting equilibrium or no new equilibrium.
• Describing “depreciation” under a peg, or “devaluation” under a float.
• Listing causes or consequences with no judgement on which matters most.
• Assuming a depreciation always improves the trade balance.
• Confusing nominal and real rates, so that a rise in prices is ignored.
• Giving examples of hybrid systems without checking they are current.

Official syllabus

OCR, A Level in Economics (H460), Version 3.0 (June 2026), for first assessment in 2021, published by Oxford Cambridge and RSA Examinations.