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

This guide is built on section 3.4.2.2 (exchange rates) of the International AS and A-level Economics specification from OxfordAQA, version 1.2. Section 3.4 is extra International A2 content. Quantitative skills from section 3.5 apply in every unit, so the sums here use percentages, graphs and elasticity. All figures are invented, and the countries and currencies are fictional.

Use it with the revision notes and the practice questions. The course pages are the OxfordAQA A-level Economics hub and the checklist. To find weak spots first, take the free diagnostics. For the current account, see the current account and policy conflicts.

What you must be able to do

Specification content (3.4.2.2)	In practice
Determination of exchange rates in a freely floating system	Draw and use demand and supply of a currency; find a new equilibrium
Causes of changes, including speculation and herding behaviour	Chain the cause to a shift, and explain self-fulfilling moves
Government intervention	Explain currency purchases and sales and interest rate changes, and their limits
Free floating, managed and fixed systems	Weigh advantages and disadvantages
Effects on individuals, firms and economic performance	Trace price effects and use elasticities
Role of the International Monetary Fund (IMF)	State and apply its roles

1. What an exchange rate is

An exchange rate is the value of one currency measured in another. Country A’s currency is the ar and Country B’s is the bel. We quote the rate as bels per ar, so 1 ar = 2.00 bel means one ar buys two bel.

Four terms must be kept apart.

• Appreciation: a rise in the value of a currency under a floating system, caused by market forces.
• Depreciation: a fall in value under a floating system, caused by market forces.
• Revaluation: a deliberate rise in the official rate by the government or central bank, under a fixed or managed system.
• Devaluation: a deliberate fall in the official rate under a fixed or managed system.

Worked example 1. The rate moves from 1 ar = 2.00 bel to 1 ar = 1.60 bel.

• Change in the ar: (1.60 - 2.00) / 2.00 = -0.20, so the ar depreciates by 20%.
• Seen from Country B, 1 bel was 1 / 2.00 = 0.50 ar and is now 1 / 1.60 = 0.625 ar. The change is (0.625 - 0.50) / 0.50 = +25%, so the bel appreciates by 25%.

The two percentages differ because each uses a different base. State which currency you mean.

2. Determination in a freely floating system

In a free float the rate emerges from buying and selling of currencies on the foreign exchange market, with no government action.

• Demand for the ar comes from foreigners buying Country A’s exports, tourists visiting A, and inflows of foreign direct investment (FDI) and portfolio investment into A. Speculators who expect the ar to rise also demand it.
• Supply of the ar comes from Country A’s residents buying imports, travelling abroad, and investing overseas.

The demand curve slopes down: a lower rate makes A’s goods and assets cheaper in bel, so more are bought. The supply curve usually slopes up: a higher rate makes imports cheaper in ar, so more are bought and more ar are supplied.

The equilibrium rate is where demand equals supply, so the market clears with no pressure to change.

Worked example 2. The table shows the market for the ar, in millions of ar per month.

Rate (bel per ar)	1.2	1.4	1.6	1.8	2.0	2.2	2.4
Demand	140	125	110	95	80	65	50
Supply	20	35	50	65	80	95	110

Demand equals supply at 2.0 bel per ar, with 80 million ar traded. Now foreign investors, attracted by higher returns in A, buy 30 million more ar at every rate. New demand is 170, 155, 140, 125, 110, 95, 80. Demand equals supply at 2.2, where both are 95. The ar has appreciated by (2.2 - 2.0) / 2.0 = 10%.

In a diagram: the vertical axis is the rate (bel per ar), the horizontal axis is quantity of ar. Demand shifts right, and the intersection with the supply curve moves up and to the right.

3. Causes of changes in the exchange rate

Anything that shifts demand or supply moves the rate. Learn each as a chain.

Cause	Chain of reasoning
Higher interest rates in A relative to elsewhere	Higher returns on A’s savings and bonds, so more portfolio inflows, so demand for the ar rises, so appreciation
Lower inflation in A than in competitors	A’s goods become more price competitive, so export demand rises and import demand falls, so appreciation
Faster income growth in A	Households buy more imports, so more ar are supplied, so depreciation
Rise in productivity or quality in A	Competitiveness improves, so export demand rises, so appreciation
Rise in FDI into A	Foreign firms buy ar to build or buy assets in A, so appreciation
Fall in confidence in A	Investors sell A’s assets, so ar supplied rises, so depreciation

Speculation and herding behaviour

Speculation is buying or selling a currency to profit from an expected change in its price. It is a large part of currency trading.

Worked example 3. A speculator spends 1,000,000 bel on ar at 2.00, getting 500,000 ar. The ar rises to 2.20 and the speculator sells. 500,000 × 2.20 = 1,100,000 bel, a profit of 100,000 bel, or 10%. If the ar had fallen to 1.90, the result would be 500,000 × 1.90 = 950,000 bel, a loss of 50,000.

Speculation can be self-fulfilling: if traders expect the ar to rise, they buy, and it rises. Herding behaviour means traders copy each other instead of judging fundamentals. Fear of missing out or of losses spreads, so the rate can overshoot well beyond what trade and investment flows justify, then reverse sharply. This makes the rate volatile.

4. Government intervention

Governments and central banks may influence the rate. The methods are:

• Buying the currency. The central bank sells foreign currency from its reserves and buys its own currency. Demand rises, so the rate rises.
• Selling the currency. It sells its own currency and buys foreign currency, adding to reserves. Supply rises, so the rate falls.
• Changing interest rates. A higher rate attracts portfolio inflows and raises the rate. A lower rate does the opposite.

Worked example 4. Country A holds the rate at 2.00 bel per ar. Confidence falls and demand drops by 25 million ar at every rate. At 2.00, demand is now 55 and supply is 80. There is excess supply of 25 million ar. To hold the rate, the central bank must buy 25 million ar, using 25 × 2.00 = 50 million bel of reserves. If reserves are 400 million bel, it can repeat this for 400 / 50 = 8 months, then runs out. Left alone, the market rate would settle at about 1.83 bel per ar, a fall of about 8%.

Limits: reserves are finite, speculators may be larger than the central bank, and a rate rise to defend the currency may slow growth, conflicting with domestic aims. Intervention suits short-lived swings, not a fundamental imbalance.

5. Exchange rate systems

System	How it works	Advantages	Disadvantages
Free floating	Market forces alone set the rate	Rate can adjust automatically to imbalances; no need to hold large reserves; interest rates can aim at domestic goals	Volatile, especially with speculation; uncertainty for traders and investors; weak currencies raise import prices
Fixed	Currency pegged to another currency at a set rate, defended by intervention	Stability and certainty; lowers risk for trade and investment; can discipline inflation	Needs large reserves; interest rates tied to defending the peg; cannot adjust to shocks; devaluation or revaluation may be forced
Managed	Floats, but the central bank intervenes to smooth or steer the rate	Reduces extreme swings while keeping some flexibility	Needs reserves; policy may be unclear; markets can test the band

A small economy trading mostly with one partner may value a peg. A large, diverse economy may prefer freedom to set interest rates for domestic goals.

6. How changes in the exchange rate affect people and the economy

Price effects

Worked example 5. A Country A exporter sells a machine for 4,000 ar. Its price in bel falls from 4,000 × 2.00 = 8,000 to 4,000 × 1.60 = 6,400, down 20%. An import costing 300 bel cost 150 ar before and now costs 300 / 1.60 = 187.50 ar, up 25%.

Why elasticities matter

Suppose Country A’s exporters keep their ar prices unchanged, exports are 100 and imports 100 (billion ar), and the ar falls 20% as above.

• Higher-elasticity case. Export demand has PED of -1.5. Foreign price falls 20%, so quantity rises 30%. Export earnings in ar become 130. Import demand has PED of -0.4. Import prices in ar rise 25%, so quantity falls 10%. Spending on imports is 100 × 1.25 × 0.90 = 112.5. The trade balance improves by 130 - 112.5 = 17.5.
• Lower-elasticity case. Export PED is -0.45 and import PED is -0.28. Export quantity rises 9%, giving 109. Import quantity falls 7%, so spending is 100 × 1.25 × 0.93 = 116.25. The balance worsens by 7.25.

Depreciation therefore helps the trade balance only if demand for exports and imports is elastic enough. Elasticities are usually lower soon after the change, because contracts and habits adjust slowly.

Effects on individuals

• A fall in the currency makes foreign holidays dearer: a hotel at 1,200 bel costs 600 ar at 2.00 and 750 ar at 1.60 (+25%).
• It raises the price of imported goods and so the cost of living.
• Export workers may gain jobs; holders of foreign assets gain; borrowers with foreign-currency debts lose.

Effects on firms

• Exporters gain price competitiveness or higher profit margins.
• Importers and firms using imported inputs face higher costs.

Worked example 6. A Country A bakery has costs of 100 a week, of which 30 is imported flour. Flour prices in ar rise 25%. New costs are 70 + 30 × 1.25 = 107.5, a rise of 7.5%. The bakery must absorb this or raise prices.

Effects on economic performance

Variable	Depreciation	Appreciation
Aggregate demand	Net exports rise if elasticities are high, so AD and growth rise	Net exports fall, so AD falls
Inflation	Imported inflation and demand-pull pressure	Cheaper imports lower inflation
Employment	Rises in export and import-competing industries	May fall in those industries
Current account	Improves only with sufficient elasticity	May worsen

Worked example 7. In the higher-elasticity case net exports rise 17.5. With a multiplier of 1.6 and spare capacity, GDP rises by 17.5 × 1.6 = 28. If GDP was 1,000, that is 2.8%. If the economy is near full capacity, the extra demand mainly raises prices.

Evaluation points: size of the change, elasticities, time lags, spare capacity, use of imported inputs, and whether exporters cut prices abroad or keep the profit.

7. The role of the IMF

The International Monetary Fund (IMF) is an international organisation of member countries. Its main roles are to promote international monetary cooperation and exchange rate stability, to lend to members with balance of payments difficulties (usually on conditions about policy changes), to monitor members’ economies and give policy advice, and to provide technical assistance. Conditions can be criticised because they may force spending cuts that slow growth.

Common errors

• Writing appreciation when a government has revalued.
• Saying depreciation always improves the trade balance.
• Using the wrong base for a currency percentage change.
• Listing causes with no chain to a shift in demand or supply.
• Saying intervention always works without mentioning reserves.

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.