PODAR INTERNATIONAL SCHOOL (IB & CAMBRIDGE)

Topic:- Unit 6.3 Foreign exchange rates (Chapter 38 Foreign exchange rates pg. 348)
Learning Objectives:-

6.3.1 definition of foreign exchange rate

6.3.2 determination of foreign exchange rate in foreign exchange market

6.3.3 causes of foreign exchange rate fluctuations

6.3.4 consequences of foreign exchange rate fluctuations

6.3.5 floating and fixed foreign exchange rates

What is an exchange rate?

Exchange rate- This is the value of one currency in terms of another currency.
For e.g.:- $1=Rs. 82

What is appreciation and depreciation?

Appreciation- When the value of one currency rises against the other currency.
Example: Earlier $1 was Rs. 70/- and now $1 is Rs. 75/-. Therefore $ has appreciated.

Depreciation- When the value of one currency falls against the other currency.
Example: Earlier $1 was Rs. 70/- and now $1 is Rs. 75/-. Therefore Rs. has been
depreciated.
What are the reasons for appreciation of a currency? FIR SC
● Rise in foreign direct investments- IF MNCs are attracted to set up in USA,
then they have to pay all of their costs in “$”, hence the demand for “$”will rise. This
may lead to appreciation of the currency
● Increase in incomes abroad- If incomes of individuals abroad rises, then they
will demand for better quality products or exports. Due to this the demand for the
currency in domestic country will rise as they will have to pay for the goods in “$”.
● Relative interest rates- This refers to the rise in the interest rate of 1 country in
relation to the rest of the world. This means that the country that offers a higher
rate of interest will attract higher investments hence the demand for their currency
will rise.
● Positive speculation- If there is positive speculation and if it is predicted that the
value of the currency will rise [optimistic about the currency], hence they buy the
currency beforehand, so the current demand for the currency increases. Due to this
the value of the currency appreciates.
● Lower cost of production- When there are lower cost of production, many
investments can come in as the cheap factors of production will have higher
demand. Due to this, these FOPs are paid in their domestic currency, due to which
the demand for the domestic currency will rise.
For e.g.:- If an Indian company opens the factory in UK then they will have to pay
workers wages, raw material, machinery cost in £. Therefore demand for £ will
increase causing £ to appreciate.
What are the reasons for depreciation of a currency? FIRSC
● Fall in foreign direct investments- IF MNCs are not attracted to set up in USA,
then they do not have to pay all of their costs in “$”, hence the demand for “$”will
fall. This may lead to depreciation of the currency
● Decrease in incomes abroad- If incomes of individuals abroad falls, then they
will not demand for better quality products or exports and switch to cheaper
options. Due to this the demand for the currency in domestic country will fall.
● Relative interest rates- This refers to the fall in the interest rate of the whole
world and not only 1 country. As interest rates are lower, the investments made will
also reduce, due to this, the demand for the currency will fall.
● Negative speculation- If there is negative speculation and if it is predicted that
the value of the currency will fall, hence they do not buy the currency beforehand,
so the current demand for the currency remains unchanged or falls. Due to this the
value of the currency depreciates.
● Higher cost of production- When there are higher cost of production, lesser
investments can come in as the expensive factors of production will have lower
demand. As the demand for FOPs will reduce, this will also cause the demand for the
domestic currency to reduce.

Advantages of depreciation:
● If PED is elastic, the value of exports will fall, hence the demand for exports rises.
This ensures that export revenue increases.
● The cost of import rises, hence the demand for imports will fall. This ensures that
import expenditure reduces.
 ● When export revenue rises and import expenditure reduces, the current account
position improves, hence there can be an increase in the current account surplus or
a decrease in the current account deficit.
● The domestic output rises due to higher exports, hence this shows a rise in the real
GDP of an economy. This leads to higher economic growth in the short run.
● To fulfil the demand for goods, there is a derived demand of labour due to which
firms employ more workers I order to meet the demand. This will help reduce
unemployment rate.
● When unemployment reduces, government expenditure on unemployment benefits
will reduce hence there will be lower opportunity costs involved.
● When employment rises, even incomes of individuals will rise, with this they have
access to a wider variety of goods and services hence they have a higher standard of
living.

Disadvantages of depreciation:
● If PED is inelastic, even though the value of exports will fall, the demand for exports
will not have such a proportionate rise. This does not ensure that export revenue
increases or it may even fall.
● Even though the cost of import rises, the demand for imports will not fall to such an
extent. Import expenditure may increase rather than reducing.
● When export revenue falls and import expenditure increases, the current account
position worsens, hence there can be a decrease in the current account surplus or an
increase in the current account deficit.
● The domestic output falls due to lesser exports, hence this shows a fall in the real
GDP of an economy. This leads to lower economic growth in the short run.
● As there is no demand for goods, there is no derived demand of labour.
Unemployment rate might increase due to this.
● When unemployment increases, government expenditure on unemployment
benefits will increase hence there will be higher opportunity costs involved.
● When employment falls, even incomes of individuals will fall, with this they do not
have access to a wider variety of goods and services hence they have a lower
standard of living.

Advantages of appreciation:
● Even though exports become expensive, there is no proportionate fall in the quantity
demanded because the PED is inelastic, hence export revenue rises.
● Although the imports become cheaper, if the PED is inelastic, there will not be a
proportionate rise in the demand due to which the import expenditure will fall.
● As the export revenue exceeds the import expenditure, the current account position
will improve, this might reduce a current account deficit or increase a current
account surplus.
 ● The domestic output rises due to higher exports, hence this shows a rise in the real
GDP of an economy. This leads to higher economic growth in the short run.
● To fulfil the demand for goods, there is a derived demand for labour due to which
firms employ more workers in order to meet the demand. This will help reduce
unemployment rate.
● When unemployment reduces, government expenditure on unemployment benefits
will reduce hence there will be lower opportunity costs involved.
● When employment rises, even incomes of individuals will rise, with this they have
access to a wider variety of goods and services hence they have a higher standard of
living.

Disadvantages of appreciation:
● Even though exports become expensive, there is a greater fall in the quantity
demanded because the PED is elastic, hence export revenue falls.
● Although the imports become cheaper, if the PED is elastic, there will be a bigger rise
in the demand due to which the import expenditure will rise.
● As the export revenue is lesser than the import expenditure, the current account
position will worsen, this might increase a current account deficit or decrease a
current account surplus.
● The domestic output falls due to lesser exports, hence this shows a fall in the real
GDP of an economy. This leads to lower economic growth in the short run.
● As there is no demand for goods, there is no derived demand of labour.
Unemployment rate might increase due to this.
● When unemployment increases, government expenditure on unemployment
benefits will increase hence there will be higher opportunity costs involved.
● When employment falls, even incomes of individuals will fall, with this they do not
have access to a wider variety of goods and services hence they have a lower
standard of living.

What are the types of exchange rates?

Fixed exchange rate- It is when the government fixes or pegs the value of its currency in
terms of another currency. Here the market forces do not determine the exchange rate.
Advantages of a fixed exchange rate:
● It creates certainty for importers and exporters
● There is less speculation regarding future rates
● It encourages and increases investments
● It helps boost business confidence
● Economic growth is achieved in the short run
Disadvantages of a fixed exchange rate:
● The government needs to have sufficient amount of reserves
● Products might become uncompetitive if exchange rate is too high
● Does not automatically offset current account balance
● If the rate cannot be maintained, there can be a huge change in value through
devaluation

Floating exchange rate- It is when the exchange rate is determined by the market forces
that is demand for and supply of the currency. Here the government does not intervene in
determining the exchange rate.

Advantages of a floating exchange rate:

 ● It can automatically offset current account balance/ Offset current account balance:-
Deficit [X<M] – Depreciation- Exports become cheaper- so the demand for exports will
increase, imports become expensive so the demand for imports decreases only if ped is
elastic -balanced
Surplus- Appreciation
● The government need not hold any extra foreign exchange reserves
● Government and central bank can focus on other important policies and objectives

Disadvantages of a floating exchange rate:

● There is a lot of speculation regarding future rates
● Creates uncertainty for the importers and exporters
● Due to high volatility, the investments are discouraged and reduced
● May not offset current account balance if PED for exports and imports is inelastic.

Q. Explain 2 reasons why an economy may have a high foreign exchange rate [4] [MJ
2015 21]
• a high demand for the currency (1) this may arise from e.g. good quality/lower price of
exports/speculation that the currency will rise in the future (1)
• a low supply of the currency (1) due to, for instance, a low demand for imports/a low
level of investment abroad (1)
• government setting a high exchange rate (1) by buying the currency/raising the
exchange rate (1)
Q Analyse why a country's exchange rate may rise in value .[6] [Mj 2014 23]
Up to 4 marks for: the government/central bank [1] may decide to raise the value of a fixed
exchange rate [1] by buying the currency [1] or raising the rate of interest [1].
Up to 3 marks for: demand for exports may rise [1], e.g. due to rise in incomes abroad/rise in
quality of domestic products/fall in domestic inflation rate/rise in domestic productivity [1] will
increase demand for the currency [1].
Up to 3 marks for: demand for imports may fall [1], e.g. due to fall in domestic incomes/rise
in quality of domestic products/rise in inflation abroad/fall in productivity abroad [1] will
reduce the supply of the currency [1].
Up to 2 marks for: FDI into the country may increase [1] which will increase demand for the
currency [1].
Up to 2 marks for: speculation [1] traders may buy the currency expecting its value to rise in
the future [1].
Up to 2 marks for: demand for the currency increases [1] supply of currency falls [1].
1 mark for: demand for the currency exceeds the supply.
Note: a maximum of 6 marks overall.
Q. Discuss whether or not a government should prevent a fall in its country’s foreign
exchange rate. [8] s19qp21
Up to 5 marks for why it should:
A fall in the exchange rate would increase the price of imports (1) this will
increase the price of imported raw materials (1) this will increase costs of
production (1) inflation may occur (1).
A rise in the price of finished products (1) will reduce the goods and
services people can buy (1) reduce living standards (1).
A fall in the exchange rate may reduce confidence in the country (1) this
may reduce investment (1).
A lower exchange rate may increase debt repayments (1) making it more
difficult for firms and the government to pay back loans (1).
Higher government spending on e.g. state benefits (1) will increase
disposable income (1) some of this might be spent on imports (1).
Up to 5 marks for why it should not:
A lower exchange rate will reduce the price of exports (1) more exports may
be sold (1) this combined with lower imports may improve the current
account balance (1).
Demand for domestic products may rise (1) this may increase output (1) so
cause economic growth (1) reduce unemployment (1).
4. Describe the difference between fixed and floating exchange rate system. [ON 2013
23 ]
Up to 2 marks for a fixed exchange rate:
• a fixed exchange rate is maintained by the government/central bank (1)
• it is maintained through intervention in the foreign exchange market, buying or selling the
currency/changes in the interest rate to maintain a particular value (1)
Up to 2 marks for a floating exchange rate:
• the value is determined by the market forces of demand and supply (1)
• the value can change frequently due to changes in demand and supply (1), e.g.
speculation/rate of inflation etc. (1)
• there is no need for a government/central bank to maintain a particular exchange rate (1)
5. Explain two benefits of a floating exchange rate system.[MJ 2015 23]
• no need to keep reserves of foreign currencies (1) as the central bank will not be buying
the currency to support its value (1)
• the exchange rate should move automatically/it is self-correcting (1) to eliminate a
current account deficit/surplus (1)
• allows a government to concentrate on other aims e.g. full employment (1) as interest
rate changes/foreign exchange dealings do not have to be undertaken (1)
• market forces determine the exchange rate (1) equilibrium price will be achieved (1)
7. Discuss to what extent a floating exchange rate system is preferable to a fixed
exchange rate system .[8][ Mj 2013 22]
8. Explain what can cause fluctuations in a floating exchange rate system.
Possible causes:
• changes in the demand for the currency
• to pay for more exports
• changes in the supply of the currency
• to pay for more imports
• changes in the balance of trade
• changes in interest rates
• economic/political state of the country; level of confidence
• speculation
• rate of inflation in relation to other countries.
A list-like approach can gain no more than 3 marks. [6]

9. Analyse how an appreciation of the exchange rate may reduce the country’s
inflation rate. [6]
An appreciation in the exchange rate means a rise in the value of the currency (1) higher
export prices (1) lower import prices (1) less competitive (1) may reduce net exports (1) may
increase imports (1) lower total demand (1) reduce demand-pull inflation (1). Lower import
prices will reduce the price of some of the products people in the country buy (1) may lower
price of raw materials (1) lower costs of production (1) reduce cost-push inflation (1). Lower
import prices and higher export prices will put pressure on domestic firms to keep prices low
(1).
Q. Analyse how a fall in a country’s foreign exchange rate could reduce a deficit on
the current account of its balance of payments. (M/J 2022 qp 22)
Deficit occurs when debit items including imports on the current account of the balance of
payments exceed credit items including exports (1).
Fall in the exchange rate would reduce price/value of the currency / depreciation/devaluation
has occurred (1) this would reduce the price of exports (1) increase price of imports (1) make
exports more competitive / imports less competitive (1) demand for exports is likely to rise /
exports increase (1) increase export revenue / money flowing into the country (1) demand for
imports is likely to fall / imports reduce / switch from imports to domestically produced
products (1) reduce import expenditure / reduce money flowing out of the country (1)
increase net exports (1) if demand is price-elastic (1).
Value of remittances/money sent home may rise (1) increasing secondary income (1).

Q. Describe how a government maintains the external value in a fixed

exchange rate system. (4 marks) [ Mj 2013 qp22]

o If the value is falling, the government will step in to buy more of the
currency.
o If the value is rising, the government will step in to sell more of the
currency.
o Governments buy foreign currencies using reserves.
o The government could also increase interest rates when the value is
falling and reduce interest rates when the value is rising.
o Reference to the mechanism by which interest rates changes affect the
exchange rate.
o Note: maximum of 4 marks.
Source:- 0455/21/Oct/Nov/2022
 Advantages of depreciation
1. Exports become cheaper so the demand for exports increases due to which the
exports revenue increases only if PED is elastic
2. Imports become expensive so the demand for imports decreases due to which
imports expenditure decreases only if PED is elastic.
3. When export revenue rises and import expenditure reduces, the current account
position improves.
4. The domestic output rises due to higher exports, hence this shows a rise in the
real GDP of an economy. This leads to higher economic growth in the short run.
5. To fulfil the demand for goods, there is a derived demand of labour due to which
firms employ more workers in order to meet the demand. This will help reduce
unemployment rate.
6. When unemployment reduces, government expenditure on unemployment
benefits will reduce hence there will be lower opportunity costs involved.

Disadvantages of depreciation

1. Exports become cheaper but the demand for exports may not increase
proportionately if PED is inelastic leading to fall in exports revenue
2. Imports become expensive but the demand for imports may not decrease
proportionately if PED is inelastic leading to increase in imports expenditure.
3. When export revenue falls and import expenditure increases, the current account
position worsens.
4. The domestic output falls due to lesser exports, hence this shows a fall in the real
GDP of an economy. This leads to lower economic growth in the short run.
5. As there is no demand for goods, there is no derived demand of labour.
Unemployment rate might increase due to this.
6. When unemployment increases, government expenditure on unemployment
benefits will increase hence there will be higher opportunity costs involved.

Advantages of appreciation:
• Even though exports become expensive, there is no proportionate fall in the
quantity demanded for exports because the PED is inelastic, hence export revenue
rises.
• Although the imports become cheaper, if the PED is inelastic, there will not be a
proportionate rise in the demand for imports due to which the import expenditure will
fall.
• As the export revenue exceeds the import expenditure, the current account position
will improve, this might reduce a current account deficit or increase a current account
surplus.
• The domestic output rises due to higher exports, hence this shows a rise in the real
GDP of an economy. This leads to higher economic growth in the short run.
• To fulfil the demand for goods, there is a derived demand for labour due to which
firms employ more workers in order to meet the demand. This will help reduce
unemployment rate.
• When unemployment reduces, government expenditure on unemployment benefits
will reduce hence there will be lower opportunity costs involved.
• When employment rises, even incomes of individuals will rise, with this they have
access to a wider variety of goods and services hence they have a higher standard
of living.

Disadvantages of appreciation:
• Exports become expensive so the demand for exports will fall and export revenue
will fall only if PED is elastic.
• Imports become cheaper so the demand for imports will increase resulting in rise in
imports expenditure only if PED is elastic.
• As the export revenue is lesser than the import expenditure, the current account
position will worsen, this might increase a current account deficit or decrease a
current account surplus.
• The domestic output falls due to lesser exports, hence this shows a fall in the real
GDP of an economy. This leads to lower economic growth in the short run.
• As there is no demand for goods, there is no derived demand of labour.
Unemployment rate might increase due to this.
• When unemployment increases, government expenditure on unemployment
benefits will increase hence there will be higher opportunity costs involved.
• When employment falls, even incomes of individuals will fall, with this they do not
have access to a wider variety of goods and services hence they have a lower
standard of living.