Explain why the value of a currency may fall in a floating exchange rate system

AQA A-Level Economics Paper 2 June 2019

Explain why the value of a currency may fall in a floating exchange rate system. (15 marks)

Exchange rates are the price of a currency in terms of another. A floating exchange rate is when the exchange rate is determined by market forces (supply and demand of the currency). 

1. One factor that can cause a currency depreciation is lower interest rates. 
2. Interest rates are the cost of borrowing or the reward for saving.
3. Lower interest rates mean that there is a lower reward for saving in the UK is lower.
4. This means that there would be more hot money flows out of the UK as people would want to take advantage of higher savings rates abroad.
5.  This causes a decrease in demand for the pound and an increase in supply of the pound.
6.  The value of the pound would fall as shown by the diagram below.

1. Another factor that can cause a currency depreciation is a worsening of the current account deficit.
2. A current account deficit is when the value of imports exceed the value of exports.
3. If there is an increase in the value of imports increase, then the supply of pounds would increase as consumers would need to sell pounds to buy a different currency.
4. Furthermore, if there is a decrease in the value of exports, this would cause demand for the pound to decrease because less pounds are needed. 
5. Demand for the pound can be derived demand from the demand for UK exports. 
6. The diagram above shows that this causes the value of the pound to fall from p1 to p2 as a result of an increase in supply and decrease in demand.

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