Exchange rates
What you'll learn
- How to read exchange-rate quotes and convert between currencies.
- How floating and fixed exchange rates are determined using demand and supply diagrams.
- Why exchange rates appreciate or depreciate.
- How to evaluate the effects of exchange-rate changes and compare exchange-rate systems.
The basic idea: currency has a price
Exchange rate
An exchange rate is the price of one currency expressed in terms of another currency. For example, £1 = US$1.25 means one pound buys 1.25 US dollars.
Exchange rates are always bilateral, meaning they compare two currencies. If you say “the pound has risen”, you should say against which currency — for example, against the US dollar or against the euro.
Reading a quote
In the quote £1 = US$1.25, the pound is the currency being priced. If the number rises to £1 = US$1.40, each pound buys more dollars, so the pound has strengthened against the dollar.
Appreciation, depreciation, devaluation and revaluation
- An appreciation is a rise in the value of a currency in a floating exchange rate system.
- A depreciation is a fall in the value of a currency in a floating exchange rate system.
- A devaluation is an official lowering of a fixed exchange rate.
- A revaluation is an official raising of a fixed exchange rate.
The quick trade effect
A stronger pound usually makes imports cheaper for UK consumers and firms, but makes UK exports more expensive for foreign buyers, assuming prices are unchanged in pounds.
Converting an import invoice
A UK firm must pay a US supplier US$120,000.
- At £1 = US$1.25, divide the dollar invoice by the number of dollars bought by one pound:
- If the pound appreciates to £1 = US$1.50, each pound buys more dollars:
- Compare the two costs: the appreciation reduces the UK firm’s import bill by £16,000.
Calculating percentage exchange-rate changes
Use the old exchange rate as the base:
%Δexchange rate=new rate−old rateold rate×100\%\Delta \text{exchange rate} = \frac{\text{new rate} - \text{old rate}}{\text{old rate}} \times 100%Δexchange rate=old ratenew rate−old rate×100Calculating appreciation
The exchange rate changes from £1 = US$1.20 to £1 = US$1.32.
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Identify the old and new rates: old = 1.20, new = 1.32.
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Substitute into the percentage change formula:
- Interpret the sign: the dollar value of £1 has risen by 10%, so the pound has appreciated by 10% against the US dollar.
Reading the quote backwards
For £1 = US$X, a higher value of X means the pound is stronger. But for US$1 = £X, a higher value of X means the dollar is stronger and the pound is weaker. Always check which currency one unit refers to.
Floating exchange rates: market determination
A floating exchange rate system is one where the currency’s value is determined mainly by market forces: the demand for and supply of the currency.
Demand for pounds comes from foreign households, firms and investors who need pounds to buy UK exports, visit the UK, or buy UK assets such as shares, property or government bonds. Supply of pounds comes from UK residents who sell pounds to buy imports, travel abroad, or purchase foreign assets.
The diagram shows a floating exchange rate for sterling. A rise in demand for pounds shifts demand right from D£1 to D£2, raising the exchange rate from ER1 to ER2. Because the vertical axis is US dollars per pound, this is an appreciation of the pound.
Predicting a demand shift
Suppose the Bank of England raises interest rates relative to the US, making UK government bonds more attractive to global investors.
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Foreign investors need pounds to buy UK bonds, so their demand for pounds increases.
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On the foreign exchange diagram, demand for pounds shifts to the right.
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The equilibrium exchange rate rises, so the pound appreciates against the dollar, making UK exports more expensive in dollar terms.
Shifts versus movements
A change in the exchange rate itself causes a movement along the demand or supply curve. A change in another factor — such as interest rates, confidence, exports or capital flows — causes the whole curve to shift.
Fixed exchange rates: pegging the currency
Fixed exchange rate system
A fixed exchange rate system is where the government or central bank commits to maintaining the currency at a target value, called a peg, against another currency or basket of currencies.
Under a fixed system, the exchange rate is not left entirely to market forces. The central bank may use foreign currency reserves — holdings of foreign currencies and other liquid assets — to buy or sell its own currency.
The diagram shows a peg above the free-market equilibrium. At the fixed rate, quantity supplied of pounds is greater than quantity demanded, creating excess supply and downward pressure on the pound. To maintain the peg, the central bank buys pounds and sells foreign reserves, increasing demand for pounds.
Maintaining an overvalued peg
Suppose the free-market rate is £1 = US$1.20, but the central bank tries to maintain a peg of £1 = US$1.40.
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The peg is above the market equilibrium, so the pound is overvalued: it is being held at a higher price than the market would choose.
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At this high price of pounds, more people want to sell pounds than buy them, creating excess supply and pressure for depreciation.
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To defend the peg, the central bank can buy pounds using US dollar reserves or raise interest rates to attract capital inflows.
Causes of exchange-rate changes
Exchange rates change when demand for or supply of a currency shifts. Important causes include:
- Relative interest rates: higher UK interest rates can attract short-term financial flows into UK assets, increasing demand for pounds.
- Relative inflation: if UK inflation is higher than trading partners’ inflation, UK goods become less competitive, which may reduce demand for pounds.
- Trade flows: rising exports increase demand for the domestic currency; rising imports increase supply of the domestic currency.
- Capital flows: foreign direct investment means long-term investment in productive assets abroad; portfolio investment means buying financial assets such as shares and bonds. Inflows tend to appreciate a currency.
- Speculation and confidence: if traders expect a currency to fall, they may sell it now, causing the fall they expected.
- Central bank action: interest-rate changes, quantitative easing, or direct intervention can affect exchange rates.
- Political and economic stability: uncertainty can reduce confidence. For example, sterling fell sharply during periods of UK political and fiscal uncertainty in 2022.
Consequences of exchange-rate changes
Trade and the current account
The current account is part of the balance of payments and records trade in goods and services, plus income flows and transfers.
A depreciation makes UK exports cheaper in foreign currency and imports more expensive in pounds. This may improve the current account, but only if demand responds enough.
The Marshall-Lerner condition says a depreciation will improve the current account if the sum of the absolute price elasticities of demand for exports and imports is greater than 1:
∣PEDX∣+∣PEDM∣>1|PED_X| + |PED_M| > 1∣PEDX∣+∣PEDM∣>1Here, price elasticity of demand means how responsive quantity demanded is to a price change.
In the short run, the current account may worsen before it improves. This is the J-curve effect: contracts are fixed, consumers take time to switch suppliers, and import demand may be price inelastic at first.
Inflation, growth and living standards
A depreciation can raise imported inflation, especially if the UK imports key goods priced in dollars, such as oil and gas. This can shift firms’ costs up and squeeze household living standards.
However, a depreciation may boost aggregate demand — total planned spending in the economy — by increasing net exports. Exporting firms may gain revenue and employment may rise.
An appreciation has the opposite effects: imports become cheaper, helping reduce inflation, but exporters may lose price competitiveness.
The effect is not automatic
The impact of an exchange-rate change depends on its size, duration, price elasticities, spare capacity, supply-chain dependence, and how much exchange-rate changes pass through into final consumer prices.
Evaluating exchange-rate systems
Floating exchange rates
Advantages:
- The exchange rate can adjust automatically to trade imbalances.
- The central bank keeps more freedom to set interest rates for domestic goals, such as inflation control.
- The government does not need to use large reserves to defend a peg.
- Depreciation can act as a shock absorber after a fall in export competitiveness.
Disadvantages:
- Volatility creates uncertainty for exporters and importers.
- A sharp depreciation can raise imported inflation.
- Speculation may cause overshooting, where the exchange rate moves more than fundamentals justify.
- Firms may face higher hedging costs to protect against currency risk.
Fixed exchange rates
Advantages:
- Stability can encourage trade and investment because firms face less currency uncertainty.
- A credible peg can help reduce inflation by imposing discipline on policymakers.
- It may benefit small, open economies that trade heavily with one major partner.
Disadvantages:
- The central bank may lose monetary policy independence.
- Defending the peg can require high interest rates, which may reduce growth and employment.
- Foreign reserves can run out.
- A fixed rate may become misaligned, damaging competitiveness.
- A speculative attack can occur when investors sell a currency heavily because they expect devaluation. The UK’s exit from the Exchange Rate Mechanism in 1992 is a classic example.
Overall judgement
There is no single best system. A large, financially open economy like the UK often benefits from a floating rate because it allows monetary policy flexibility. But a small economy with very close trade links to one partner may prefer a fixed rate if it has enough reserves and credibility to maintain it.
In the exam
- Always state the exchange-rate quote clearly, such as £1 = US$1.25, and explain whether the pound has appreciated or depreciated.
- For diagrams, label the vertical axis as the exchange rate and show whether demand or supply of the currency shifts.
- For evaluation, use “it depends”: short run versus long run, elasticities, inflation effects, stakeholder impacts, and whether the economy uses a fixed or floating system.
Check yourself
- If £1 = US$1.30 changes to £1 = US$1.17, what has happened to the pound and by what percentage?
- On a foreign exchange diagram, what happens if overseas investors buy more UK assets?
- Why might a depreciation fail to improve the current account in the short run?
