Explain how a floating exchange rate may help to correct a trade surplus

AQA A-Level Economics Paper 2 June 2018

Extract C (lines 8–9) states ‘Trade deficits and surpluses may be selfcorrecting in a floating exchange rate system.’

With the help of a diagram showing the supply of and demand for a currency, explain how a floating exchange rate may help to correct a trade surplus. (9 marks)

1. Exchange rates are the price of a currency in terms of another.
2. In a floating exchange rate system, the value of the currency is determined by market forces (demand and supply).
3. A trade surplus means that the value of exports exceed the value of imports.

1. If UK exports increase, there is a greater demand for UK goods, and therefore a greater demand for the pound.
2. If imports into the UK decrease, there is a lower demand for foreign goods, and therefore a lower demand for the foreign currency, and therefore a lower supply of the pound.
3. As demand for the pound increases and supply of the pound falls, the value of the pound increases from p1 to p2.
4. As the pound appreciates, imports become cheaper and exports become more expensive.
5. This means that imports are likely to increase and exports are likely to fall, causing the trade surplus to fall.

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