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

This guide follows the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. It covers the first part of the topic Exchange rates, in the area of study The global context, which sits in the Macroeconomics content (Component 02). The specification labels none of it as AS or Extension. Every country, currency and figure below is invented and illustrative.

Plan revision with the OCR Economics hub, the printable checklist and the free diagnostics. Then use the revision notes and the practice questions. See also the macroeconomics overview. Purchasing power parity, the Marshall-Lerner condition, the J-curve and managing a currency for competitiveness are separate units.

What this guide covers

Specification statement	Where it is taught
Explain what is meant by an exchange rate	Section 1
Explain, with a diagram, how rates are determined in fixed and floating systems	Section 2
Explain bilateral, effective, nominal and real measures	Section 3
Explain trends in exchange rate data	Section 4
Evaluate the causes of exchange rate changes	Section 5
Evaluate the consequences of exchange rate changes	Section 6
Explain a hybrid system and give current examples	Section 7
Evaluate the merits and drawbacks of different systems	Section 8

1. The meaning of an exchange rate

An exchange rate is the amount of one currency needed to obtain a single unit of another, so it is that currency’s price. Country A uses the luma and Country B uses the bex. If 1 bex = 2.50 luma, the rate can be quoted either way: 2.50 luma per bex, or 0.40 bex per luma (1 ÷ 2.50).

Terms matter. Under a floating system a currency appreciates or depreciates. Under a fixed system the authorities revalue or devalue it.

Worked example 1. The rate moves from 2.50 to 2.80 luma per bex.

• Bex per luma before: 1 ÷ 2.50 = 0.4000. After: 1 ÷ 2.80 = 0.3571.
• Change in the luma’s value: (0.3571 − 0.4000) ÷ 0.4000 = −10.7%. The luma has depreciated.
• Change in the bex’s value in luma: (2.80 − 2.50) ÷ 2.50 = +12.0%.
• A 40-bex good rises from 100 luma to 112 luma.

The percentages differ because each starts from a different base. Quote the currency you are asked about.

2. How exchange rates are determined

Floating system

A floating (flexible) system lets demand and supply in the foreign exchange market fix the rate, and the central bank promises no particular value.

Draw the market for Country A’s currency. The vertical axis is the price of the luma in bex. The horizontal axis is the quantity of lumas traded per period. Demand slopes downward and supply slopes upward.

• Demand for lumas comes from foreign buyers of A’s exports, foreign investors buying A’s assets or building plants there, tourists visiting A, and speculators expecting the luma to rise.
• Supply of lumas comes from A’s residents buying imports, A’s investors buying foreign assets, and speculators expecting the luma to fall.

Price of luma
(bex per luma)
 0.50 |- - - - - - - X2   (D1 meets S)
 0.40 |- - - X1           (D meets S)
      +------------------------------
        600   700       Quantity of lumas

D1 is demand after the rise in exports. S and D cross at X1; S and D1 cross at X2.

Worked example 2. Illustrative schedules: demand Qd = 1000 − 1000p and supply Qs = 200 + 1000p (millions of lumas, p in bex).

• Equilibrium: 1000 − 1000p = 200 + 1000p, so p = 0.40 and Q = 600.
• Foreign demand for A’s exports rises by 200 at every price: Qd = 1200 − 1000p.
• New equilibrium: 1200 − 1000p = 200 + 1000p, so p = 0.50 and Q = 700.
• The luma has appreciated by (0.50 − 0.40) ÷ 0.40 = 25%.

A shift of demand to the right (or supply to the left) raises the rate. A shift of demand to the left (or supply to the right) lowers it.

Fixed system

In a fixed (pegged) system the central bank commits to a target rate, often against another currency or a basket. The market curves still exist, but the central bank must stop the rate leaving the target.

Take Example 2 with a peg at 0.40 bex per luma and the demand rise of 200.

• At 0.40: Qd = 1200 − 400 = 800 and Qs = 200 + 400 = 600. There is excess demand of 200 lumas.
• The central bank supplies 200 lumas and buys foreign currency. Its reserves rise by 200 × 0.40 = 80 bex.

Now reverse it: demand falls by 200, so Qd = 800 − 1000p. At 0.40, Qd = 400 and Qs = 600, an excess supply of 200 lumas. The central bank must buy 200 lumas and spend 80 bex of reserves. Reserves are finite, so intervention alone cannot defend a peg under sustained selling.

Other defences: raise interest rates to attract capital (a rightward shift of demand), tighten capital controls, or accept a devaluation. Each has a cost (Section 8).

3. Measures of exchange rates

Measure	What it shows
Bilateral	The rate between two currencies only
Effective (trade-weighted)	An index of the currency against a basket of partners, weighted by trade shares
Nominal	Market value, with no adjustment for prices
Real	Nominal value adjusted for price levels at home and abroad

Bilateral and effective

A currency may rise against one partner and fall against another. The effective exchange rate (EER) weights each bilateral index by trade share.

Worked example 3. Illustrative trade with partners B, C and D is 100, 60 and 40 (billion luma-equivalent), total 200, so weights are 0.50, 0.30 and 0.20. Bilateral indices (base year 100) are 110, 95 and 90.

• EER = (0.50 × 110) + (0.30 × 95) + (0.20 × 90) = 55 + 28.5 + 18 = 101.5.
• The luma rose against B, fell against C and D, and rose 1.5% overall.

Nominal and real

A real rate adjusts for relative inflation. A simple bilateral version is real rate = nominal rate (foreign currency per unit of home currency) × home price level ÷ foreign price level. A rising real rate means home goods are becoming dearer relative to foreign goods.

Worked example 4. Base year: nominal 0.40 bex per luma, price levels 100 (A) and 100 (B), so real rate = 0.40 × 100 ÷ 100 = 0.40 (index 100).

• Next year the nominal rate is unchanged at 0.40, but prices are 110 in A and 102 in B.
• Real rate = 0.40 × 110 ÷ 102 = 0.4314, an index of 107.8.
• A real appreciation of 7.8% occurred with no nominal change. Had the luma also depreciated nominally to 0.36, the real rate would be 0.36 × 110 ÷ 102 = 0.3882, an index of 97.1.

4. Trends in exchange rate data

Read a series for direction (a rising value index means appreciation), size, turning points and volatility.

Worked example 5. Illustrative EER index for A: Years 1 to 6 = 100, 104, 109, 103, 96, 98.

• Year-on-year changes: +4.0%, +4.8%, −5.5%, −6.8%, +2.1%.
• Peak to trough (Year 3 to Year 5): (96 − 109) ÷ 109 = −11.9%.
• Over the whole period: (98 − 100) ÷ 100 = −2.0%, a net fall.
• Explanation: a rising phase, a reversal after Year 3 and a partial recovery. The average (101.7) hides a swing of 13 index points (109 to 96). Link turning points to causes and say whether each is temporary.

Where a nominal index falls but the real index does not, relative inflation has absorbed the depreciation.

5. Causes of exchange rate changes

Evaluate by asking which cause dominates, how large it is and how long it lasts.

• Interest rate differentials. A higher rate attracts short-term capital (“hot money”), raising demand for the currency. The effect weakens if the rise is expected to be reversed or if inflation erodes the return.
• Inflation relative to partners. Higher relative inflation makes exports dearer and imports cheaper, so demand for the currency falls over time.
• Relative growth. Faster growth raises import demand and supply of the currency, though it can also attract investment.
• Investment and trade flows. Strong demand for exports or a surge in inward direct investment raises demand for the currency.
• Speculation and confidence. Expectations are self-fulfilling in the short run. Political shocks or doubts about debt can trigger sharp falls.

Short-run movements are mostly financial flows and expectations. Longer-run movements follow relative prices and trade. Separate the two.

6. Consequences of exchange rate changes

A depreciation has these effects, and an appreciation reverses them.

Worked example 6. The rate moves from 0.40 to 0.36 bex per luma, a 10% fall.

• A component costing 50 bex rises from 125 luma to 138.89 luma, up 11.1%.
• An export priced at 200 luma falls from 80 bex to 72 bex if the luma price is held, so foreign buyers pay 10% less.
• If imports are 20% of consumer spending and the full rise is passed on, the direct effect on the price level is 0.20 × 11.1 = 2.2 percentage points.
• A foreign debt of 500 bex rises from 1,250 luma to 1,388.9 luma, an extra 138.9 luma.

Consequences to weigh:

• Competitiveness and trade. Exports cheaper abroad, imports dearer. Whether the trade balance improves depends on price elasticities, covered in the Marshall-Lerner unit.
• Inflation. Imported goods and raw materials cost more, raising costs and prices. Spare capacity limits how far firms pass this on.
• Output and employment. Higher net exports add to aggregate demand, but dearer inputs reduce short-run aggregate supply.
• Debt and investment. Debts in foreign currency become heavier. Foreign investors may value domestic assets less in their own currency.
• Uncertainty. Volatile rates raise risk for traders and investors.

Judge by size, time lags, openness and how much capacity is idle.

7. Hybrid systems

A hybrid (managed or intermediate) system mixes features of fixed and floating. The market sets the rate day to day, but the central bank intervenes, sets a band, or steers the rate against a basket.

Type	How it works
Managed float	Rate floats, but the central bank buys and sells to smooth movements
Band or target zone	Rate floats within limits; intervention occurs at the edges
Crawling peg	Target rate adjusted gradually by a set rule

Current examples. Treat classifications as changeable and check the latest International Monetary Fund (IMF) table before an exam. In its 2023 report, the IMF classes China as an “other managed arrangement” and Singapore as a “crawl-like arrangement”. Singapore uses the exchange rate as its main monetary policy tool. A currency board, as in Hong Kong, is a hard peg rather than a hybrid: it contrasts with the managed floats above.

8. Merits and drawbacks of different systems

System	Merits	Drawbacks
Floating	Adjusts automatically; interest rates free for domestic goals; no need for large reserves	Volatile; uncertainty for trade; imported inflation after falls
Fixed	Stable, lower risk for trade and investment; imposes discipline on inflation	Needs large reserves; interest rates tied to the anchor; fixed rate may be wrong; attacks by speculators
Hybrid	Some stability plus some flexibility	Can lack credibility; reserves still needed; may invite speculation if the band is hard to defend

Worked example 7. Country A holds reserves of 120 bn and imports 30 bn a month. Reserves cover 120 ÷ 30 = 4 months of imports, so a long defence of a peg is not possible.

Evaluation. The best system depends on:

• the size and openness of the economy,
• the quality of its institutions and the credibility of the central bank,
• the size of its reserves,
• whether shocks are domestic (floating helps) or financial and global (a peg may help),
• its inflation record: a peg can import low inflation.

Common errors

• Mixing up which currency is the price, and so which way the quote moved.
• Giving a percentage change for the wrong currency.
• Leaving the diagram axes unlabelled.
• Saying a currency “depreciates” under a peg or “devalues” under a float.
• Concluding an appreciation is always good. The answer depends on the objective and the time frame.

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.