How Are Floating Exchange Rates Determined?
Learn how demand and supply determine a floating exchange rate, why currencies appreciate or depreciate, and the key distinction to make in exams.
A floating exchange rate is determined by demand for and supply of a currency in the foreign exchange market. Its value changes when that demand or supply changes, without a fixed rate being maintained by the government.
Scope: Cambridge International AS Level Economics, Exchange rates: 6.4.2 covers determination of a floating exchange rate, and 6.4.4 covers changes in demand for and supply of the currency.
Where do demand and supply come from?
People and firms demand a currency when they need it to buy goods, services or assets from that country. For example, foreign buyers of a country’s exports need its currency to pay exporters. Investors buying assets there may also demand it.
People supply that currency when they exchange it for another. Importers, for example, may sell their own currency to pay overseas suppliers. Investors moving money abroad may do the same.
What makes the rate change?
Suppose overseas demand for a country’s exports rises. Foreign buyers demand more of its currency. If supply is unchanged, the currency’s exchange rate rises: it appreciates. Conversely, if residents buy more imports, they may supply more of their currency to obtain foreign currency. If demand is unchanged, its exchange rate falls: it depreciates.
The same reasoning applies to financial flows. Higher returns on a country’s assets may attract overseas investors and increase demand for its currency, although other factors can affect their decisions.
Exam mistake to avoid: state which currency you are discussing. A rise in the value of one currency relative to another means the other has fallen relative to it. Also, when explaining a change in the exchange rate, identify what has changed demand or supply; saying only that the rate is ‘set by the market’ does not explain the direction of the change.
