OxfordAQA International AS and A-level Economics: Exchange rates (9640) – Revision Notes

Condensed recall for section 3.4.2.2 (exchange rates) of the OxfordAQA International AS and A-level Economics specification (version 1.2). Section 3.4 is extra International A2 content. For full explanations and longer worked examples, use the study guide. Test yourself with the practice questions, tick off the checklist, and see the course hub. The free diagnostics show which topics to revise first. All figures are invented.

Definitions

Term	Meaning
Exchange rate	The value of one currency measured in units of another
Appreciation	Rise in a currency’s value under a floating system, caused by market forces
Depreciation	Fall in value under a floating system, caused by market forces
Revaluation	Deliberate rise in the official rate (fixed or managed system)
Devaluation	Deliberate fall in the official rate (fixed or managed system)
Free float	Rate set by demand and supply with no intervention
Fixed rate	Rate pegged at a set value and defended by the central bank
Managed float	Market sets the rate, but the central bank intervenes to smooth or steer it
Reserves	Foreign currency and other assets the central bank can use to intervene
Speculation	Trading a currency to profit from an expected price change
Herding behaviour	Traders copying each other instead of judging fundamentals

Percentage changes in a rate

Percentage change = (new rate - old rate) / old rate × 100.

Reminder: 1 ar = 2.00 bel falls to 1 ar = 1.50 bel. The ar changes by (1.50 - 2.00) / 2.00 = -25%. The bel was worth 0.50 ar and is now worth 1 / 1.50 = 0.667 ar, a rise of 33.3%. A fall of 25% in one currency is a rise of 33.3% in the other, because the bases differ.

Determination under a free float

Demand for the home currency comes from	Supply of the home currency comes from
Foreign buyers of exports	Residents buying imports
Foreign tourists	Residents travelling abroad
Inflows of FDI and portfolio investment	Outflows of FDI and portfolio investment
Traders buying in expectation of a rise	Traders selling in expectation of a fall

Diagram in words: the vertical axis shows the exchange rate (units of foreign currency per unit of home currency). Horizontal axis, quantity of home currency. Demand slopes down, supply slopes up, and they meet at the equilibrium rate.

Method in steps:

1. Identify whether demand or supply has shifted, and why.
2. State the direction of the shift.
3. State the new equilibrium: a higher or lower rate, and a larger or smaller quantity traded.
4. Name the result: appreciation or depreciation.

Worked reminder: the market for Country C’s currency, the mer, is measured in kel per mer.

Rate (kel per mer)	0.8	1.0	1.2	1.4
Demand (m mer)	60	50	40	30
Supply (m mer)	20	30	40	50

Equilibrium is 1.2, with 40 million mer traded. If higher interest rates add 20 million to demand at every rate, new demand is 80, 70, 60, 50. It now equals supply at 1.4. The mer has appreciated by (1.4 - 1.2) / 1.2 = 16.7%.

Causes of changes (shift and effect)

Cause	Curve that shifts	Result
Home interest rates rise relative to abroad	Demand right	Appreciation
Domestic inflation higher than abroad	Demand left, supply right	Depreciation
Faster domestic income growth	Supply right (more imports)	Depreciation
Higher productivity or quality	Demand right	Appreciation
FDI inflow rises	Demand right	Appreciation
Loss of confidence	Demand left, supply right	Depreciation
Speculators expect a rise	Demand right, supply left	Appreciation, possibly beyond fundamentals

Speculation and herding. Expectation causes action, action moves the rate, and the move confirms the expectation. Herding makes this stronger: rates overshoot, then fall back sharply. Worked reminder: spend 800,000 bel on ar at 2.00 and you hold 400,000 ar. Sell at 2.10 and you receive 840,000 bel, a 5% gain.

Government intervention

Method	Action	Effect on the rate
Buy the currency	Sell reserves of foreign currency, buy home currency	Demand rises, rate rises
Sell the currency	Sell home currency, add to reserves	Supply rises, rate falls
Raise interest rates	Raises returns on home assets	Demand rises, rate rises
Cut interest rates	Lowers returns on home assets	Demand falls, rate falls

Cost of defending a rate = excess supply of the currency × the target rate. If excess supply is 25 million ar at 2.00 bel per ar, the bank uses 50 million bel of reserves. Divide reserves by this figure to see how long it can last.

Limits: finite reserves, large speculative flows, conflict with domestic goals when interest rates are used, and little help against a lasting imbalance.

Exchange rate systems

	Free float	Fixed	Managed float
Rate set by	Market	Government, defended by intervention	Market, with intervention
Reserves needed	Small	Large	Moderate
Stability	Low	High	Moderate
Interest rates	Free for domestic goals	Tied to the peg	Partly constrained
Adjusts to shocks	Automatically	Only by devaluation or revaluation	Partly

Evaluation: the best system depends on trade patterns, size of reserves, credibility of the authorities and how exposed the economy is to shocks.

Effects of a change in the rate

	Depreciation	Appreciation
Price paid by foreign buyers of exports	Fall	Rise
Price paid by home buyers of imports	Rise	Fall
Exporters	Gain competitiveness	Lose competitiveness
Firms with imported inputs	Costs rise	Costs fall
Consumers	Dearer imports and foreign holidays	Cheaper imports and holidays
Borrowers in foreign currency	Debt burden rises	Debt burden falls
Inflation	Tends to rise	Tends to fall
AD and growth	Rise if net exports rise	Fall if net exports fall

Elasticity condition. After a depreciation, the trade balance improves only if the rise in export earnings exceeds the rise in import spending. High price elasticities of demand for exports and imports make that likely. Low elasticities, which are common in the short run, can worsen the balance.

Worked reminder: ar falls 10%, so exports priced in bel fall 10%. With PED of -0.6, quantity rises 6%. The bel value of exports is 0.90 × 1.06 = 0.954 of the old value, a fall of 4.6%. The ar value, with ar prices held, rises 6%.

Cost pass-through reminder: a firm with 25% of costs imported faces a 12% rise in import prices. Total costs rise 0.25 × 12 = 3%.

Evaluating a change in the exchange rate

Build each judgement as a chain, then qualify it.

1. A depreciation makes exports cheaper for foreigners and imports dearer for residents.
2. With elastic demand, export volumes rise and import volumes fall, so net exports and AD rise.
3. With spare capacity, output and employment rise. Near full capacity, prices rise instead.
4. Dearer imported inputs raise costs and inflation, and the gain may fade if wages and prices follow.
5. Judge: the effect depends on elasticities, time, spare capacity and how far firms pass the change on.

The IMF

• Promotes international monetary cooperation and exchange rate stability.
• Lends to members facing balance of payments difficulties, usually with conditions.
• Monitors members’ economies and advises on policy.
• Provides technical assistance.
• Criticism: conditions such as spending cuts may slow growth.

Must-know distinctions

• Appreciation and depreciation are market-driven. Revaluation and devaluation are official decisions.
• A fall in the exchange rate does not mean an improvement in the trade balance.
• Defending a rate with reserves is different from defending it with interest rates.
• A weaker currency helps exporters and hurts importers.

Quick self-test

1. Define appreciation.
2. 1 ar = 2.00 bel falls to 1.50. By what percentage does the ar change?
3. A good costs 3,000 ar. What is its price in bel at 2.00 and at 1.50?
4. A 900-bel import: find its ar price at 2.00 and at 1.50, and the percentage rise.
5. Give two causes of a rise in demand for a currency.
6. Why can a central bank not defend a rate indefinitely using reserves?
7. State the difference between devaluation and depreciation.
8. Export PED is -0.6 and the foreign price falls 10%. Find the change in quantity and in foreign-currency revenue.
9. Name one role of the IMF.
10. A firm has 25% of its costs imported and import prices rise 12%. By how much do its costs rise?

Answers

1. A rise in the value of a currency under a floating system, caused by market forces.
2. -25%.
3. 6,000 bel at 2.00; 4,500 bel at 1.50.
4. 450 ar at 2.00; 600 ar at 1.50; a rise of 33.3%.
5. For example higher interest rates, a rise in export demand, or an inflow of FDI.
6. Its reserves are finite and run out.
7. Devaluation is a deliberate official fall under a fixed or managed system; depreciation is a market-driven fall under a floating system.
8. Quantity rises 6%. Foreign-currency revenue changes by 0.90 × 1.06 = 0.954, so falls 4.6%.
9. For example lending to members with balance of payments problems, or monitoring economies.
10. 0.25 × 12 = 3%.

Where marks are usually lost

• Mixing up appreciation with revaluation, or depreciation with devaluation.
• Reading a percentage change from the wrong base.
• Drawing the diagram the wrong way round, with the exchange rate on the wrong axis or the wrong currency named.
• Moving the curve without saying which one shifts and why.
• Asserting that depreciation raises exports and improves the balance with no elasticity.
• Forgetting that import prices rise after depreciation.
• Treating intervention as free and without limits.
• Ending without a judgement on size, time lags or spare capacity.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), specification version 1.2, first teaching September 2020, published by OxfordAQA: section 3.4.2.2.