Exchange Rates | A-Level Economics Notes

These revision notes cover everything you need to know about Exchange Rates for A-Level Economics. They're designed for students studying AQA A-Level Economics, Edexcel A-Level Economics, and Edexcel International A-Level Economics. Written by Jaisul Naik, UCL Economics graduate and A-Level Economics tutor since 2017.

What is an exchange rate?

Exchange rates are the price of one currency in terms of another currency.

What is a fixed exchange rate?

A fixed exchange rate is when the value of the currency is controlled by the central bank.

They central bank can buy or sell foreign currency reserves or domestic currency reserves.

What is a floating exchange rate?

A floating exchange rate is when the value of the currency is determined by market forces (supply and demand).

What is the impact of a large trade deficit on the exchange rate?

1. a trade deficit is when the value of imports exceeds the value of exports
2. high imports means that supply of the pound is high
3. low exports means that demand for the pound is low
4. this means that the value of the pound would fall

What is the impact of a large trade surplus on the exchange rate?

1. a trade surplus is when the value of exports exceeds the value of imports
2. high exports means that there is a high demand for the pound
3. low imports means that there is low supply of the pound.
4. this means that the value of the pound would increase

What is the impact of higher interest rates on the exchange rate?

1. interest rates are the cost of borrowing or reward for saving
2. higher interest rates incentivises people to buy the pound as they can get a higher return on their savings
3. this is called hot money flows into the UK.
4. as there is an increase in demand for the pound, the value of the pound would increase.

What is the impact of lower interest rates on the exchange rate?

1. interest rates are the cost of borrowing or reward for saving
2. people in the UK would sell the pound and buy another currency where they can get a higher return on their savings.
3. this means that there are hot money flows out
4. this means that there is an increase in supply of the pound
5. this means that the value of the pound would fall

How does a central bank devalue a currency?

1. if the UK followed a fixed or managed exchange rate system
2. the central bank would own reserves of the pound and the dollar
3. the Bank of England would sell more pounds and buy more dollars
4. this leads to an increase in supply of the pound and an increase in demand for the dollar
5. this causes the price of the pound to decrease and the price of the dollar to increase, therefore a devaluation of the pound.

How does a central bank revalue a currency?

1. if the UK followed a fixed or managed exchange rate system
2. the central bank would own reserves of the pound and the dollar
3. the Bank of England would sell more dollars and buy more pounds
4. this leads to an increase in supply of the dollar and an increase in demand for the pound
5. this causes the price of the pound to increase and the price of the dollar to decrease, therefore a revaluation of the pound.

What are two impacts of a strong currency?

One impact of a strong currency is a worse trade balance

1. imports become cheaper and exports become more expensive
2. this could cause the value of imports to increase and the value of exports to decrease
3. this means that the trade deficit would worsen
4. AD = C + I + G + (X-M)
5. this means that aggregate demand to shift to the left
6. this causes real gdp to decrease
7. this means that unemployment is likely to increase because demand for labour is derived from the demand for goods and services
8. the price level also decreases from pl1 to pl2

Another impact of a strong currency is a decrease in costs of production

1. imports become cheaper
2. this causes costs of production to decrease
3. this also causes short-run aggregate supply to shift to the right
4. gdp
5. unemployment
6. inflation

What are two impacts of a weak currency?

One impact of a weak currency is an improvement in the trade balance

1. exports become cheaper and imports become more expensive
2. trade deficit improves
3. aggregate demand shifts to the right
4. real gdp increases and unemployment decreases
5. price level increases

Another impact of a weak currency is an increase in costs of production

1. imports become more expensive
2. this means that costs of production increase.
3. this causes short-run aggregate supply to shift to the left
4. real gdp decreases and unemployment increases
5. this causes cost push inflation

What does the J-curve show?

Currency depreciation

The J-curve shows that whenever a currency depreciates, the trade balance is likely to worsen before it improves. This is because demand for imports and exports is inelastic at first and becomes more elastic over time.

Currency appreciation

The J-curve shows that whenever a currency appreciates, the trade balance is likely to improve before it worsens. This is because demand for imports and exports is inelastic at first and becomes more elastic over time.

What is the Marshall-Lerner condition?

Currency depreciation

The Marshall Lerner condition states that the trade balance would only improve if the PED of exports + the PED of imports is greater than 1

Currency appreciation

The Marshall Lerner condition states that the trade balance would only worsen if the PED of exports + the PED of imports is greater than 1

Summary questions

1. What is an exchange rate?
2. What is a fixed exchange rate?
3. What is a floating exchange rate?
4. What is the impact of a large trade deficit on the exchange rate?
5. What is the impact of a large trade surplus on the exchange rate?
6. What is the impact of higher interest rates on the exchange rate?
7. What is the impact of lower interest rates on the exchange rate?
8. How does a central bank devalue a currency?
9. How does a central bank revalue a currency?
10. What is the impact of a strong currency?
11. What is the impact of a weak currency?
12. What does the J-curve show?
13. What is the Marshall-Lerner condition?

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