Exchange rate — floating determination
An exchange rate is the price of one currency in terms of another — e.g. £1 = 1.25 US dollars. Under a floating system, market forces set it. Demand for the currency comes from foreigners buying exports, investing inward, or speculating on a rise; supply comes from residents buying imports, investing abroad, or selling. Demand above supply → the rate rises (appreciates); supply above demand → it falls. Read it both ways: £1 = 1.25 dollars means 1 dollar = £0.80.
Causes of appreciation and depreciation
A currency appreciates when demand rises or supply falls, and depreciates in reverse. Appreciation: higher domestic interest rates (hot-money inflows), lower inflation (exports more competitive), a trade surplus, positive speculation. Depreciation: lower interest rates (capital outflows), higher inflation, a trade deficit, negative speculation. The interest-rate → exchange-rate chain is a favourite exam mechanism.
Effects of a rate change (SPICED)
Appreciation: exports become dearer abroad and imports cheaper, so the BoP (balance of payments) current account tends to worsen — but cheaper imports ease cost-push inflation. Depreciation: exports cheaper, imports dearer, so the current account may improve long-term (after a J-curve worsening), but dearer imported inputs raise inflation. The mnemonic SPICED — Strong Pound: Imports Cheaper, Exports Dearer — fixes the direction.
Drawn from real examiner reports.
Appreciation makes exports dearer
Saying 'appreciation makes our exports cheaper' is backwards — appreciation makes exports more expensive for foreign buyers. If the pound rises from £1 = 1.20 to £1 = 1.50 dollars, a £100 product costs foreigners 150 dollars instead of 120, so exports become less competitive and volumes fall. Get the direction wrong and the whole chain runs backwards, losing marks.
Recurring error identified in multiple 4EC1 examiner reports: candidates who apply common sense rather than economic theory frequently reverse the direction of exchange rate effects on trade competitiveness.
Define the rate as a currency pair
A 2-mark definition needs two parts: the exchange rate is (1) the price of one currency (2) in terms of another. 'The value of money' or 'the price of currency' earns only 1 mark, and restating the term earns nothing. A full answer: the price of one currency measured in units of another — e.g. how many US dollars one pound buys.
November 2024 Paper 2, Q2(d): definition questions require two conceptually distinct parts — restating the term or giving only an example scores zero.
Currency answers need the unit
On a calculate question, a correct number with no unit loses a mark: write the currency symbol and unit (e.g. million, billion), and put the % sign on a percentage change. Elasticity answers have no unit, but currency answers always do. Show your working too — it banks a method mark even if the final figure is wrong.
November 2024 Paper 2, Q1(e) and November 2024 Paper 1, Q4(a): omitting currency units or the percentage sign from calculate answers costs 1 mark — a recurring problem across sittings.
Read the exchange rate both ways
An exchange rate can be read in either direction. If £1 = 1.25 US dollars, then 1 dollar = 1 ÷ 1.25 = £0.80. To convert pounds to dollars, multiply by the rate; to convert dollars to pounds, divide by it. Mixing up which way to apply the rate is a common calculation slip — decide which currency you start from first.
Depreciation improves the balance only later
Depreciation does not improve the current account instantly. The J-curve shows it worsens first: in the short run contracts and volumes are fixed, so dearer imports raise the import bill before export volumes respond. Only later, as buyers adjust, do exports rise and imports fall — and only if demand is price-elastic (the Marshall-Lerner condition).
A stronger currency is not always good
A rising exchange rate is not automatically 'good'. Appreciation helps importers and firms using foreign inputs and eases inflation, but makes exports dearer and can worsen the current account. Depreciation does the reverse. Whether it helps depends on who you are (exporter or importer) and the economy's priorities.
DACE: direction, apply, counter, end
For a 12-mark rate Assess use DACE: Direction — define appreciation or depreciation; Apply — the effect on exporters and importers, using the data; Counter — the J-curve or the Marshall-Lerner condition; End — a judgement conditional on elasticity.
SPICED fixes the direction
Use SPICED — Strong Pound: Imports Cheaper, Exports Dearer. So appreciation means cheaper imports and dearer exports; depreciation is the opposite. Anchor every rate chain to SPICED first, then build the reasoning, so the direction is never backwards.
Explain rates via currency demand/supply
To explain why a currency moves, route the chain through the demand for and supply of the currency. E.g. higher interest rates → investors seek returns → they buy the currency → demand rises → it appreciates. Naming the demand or supply shift earns the analysis marks.
Name a stakeholder for each effect
When assessing a rate change, apply it to named stakeholders, not 'the economy': exporters (sales), importers (prices), firms using imported inputs (costs). Two developed stakeholder chains applied to the data reach the higher bands; a vague 'it affects trade' does not.
An exchange rate is the price of one currency expressed in terms of another. For example:
This means one pound sterling buys 1.25 US dollars. You can always invert the rate:
Key vocabulary:
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