Cambridge (CIE) IGCSE Your notes

Economics
6.3 Foreign Exchange Rates
Contents
Understanding Foreign Exchange Rates
Floating Exchange Rates
Consequences of Changes in Foreign Exchange Rates

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 Understanding Foreign Exchange Rates
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An introduction to exchange rates

An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18
International currencies are essentially products that can be bought and sold on the
foreign exchange market (forex)
Exchange rates are important because they determine how much of a foreign currency
you can get when you exchange your own currency — which affects trade, investment,
tourism and international finance

Reasons for buying and selling foreign currencies

Countries, businesses and individuals buy and sell foreign currencies for many reasons
The demand and supply of different currencies in the foreign exchange market is
influenced by the following:

1. Trade in goods and services

Importers need to buy foreign currencies to pay for goods and services from other
countries
Exporters, on the other hand, often receive payment in foreign currencies and
exchange them into their own currency

2. Speculation
Currency traders (speculators) buy and sell currencies to make a profit from changes in
exchange rates.
For example, if a trader expects the euro to rise in value, they might buy euros now
and sell them later at a higher rate

3. Government intervention
Governments and central banks may buy or sell their own currency to influence its value
This is called exchange rate intervention and is often done to help control inflation,
support exports, or maintain economic stability

4. Profit, interest and dividend payments

When businesses or investors earn profits, interest, or dividends from other countries,
they often need to convert the foreign currency earnings into their own currency

5. Workers’ remittances
Many people work in foreign countries and send money home to their families
(remittances)

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 These remittances involve converting the worker’s earnings from the currency they are
paid in into the home country’s currency
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6. Investment in capital goods
Firms and governments may invest in machinery, buildings, or infrastructure from other
countries
To do this, they need to buy the seller’s currency, which increases demand in the
foreign exchange market

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 Floating Exchange Rates
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Key exchange rate definitions

A floating exchange rate is one that is determined by the forces of demand and supply
in the foreign exchange market, without direct government or central bank control
Appreciation occurs when the value of a currency rises compared to another currency in
a floating system (e.g. £1 = $1.25 → £1 = $1.35)
A depreciation occurs when the value of a currency falls compared to another currency
in a floating system (e.g. £1 = $1.25 → £1 = $1.10)

Determination of the foreign exchange

rate
Different currencies can be bought and sold, just like any other product
The equilibrium exchange rate is where the quantity of a currency demanded equals
the quantity supplied
At this rate, the market is in balance — there is no shortage or surplus of the currency
If demand increases or supply decreases, the currency appreciates
If demand decreases or supply increases, the currency depreciates

Demand for a currency comes from:

Foreigners buying the country’s exports
Tourists visiting the country
Foreign investors buying assets, shares or property
Speculators who expect the currency to appreciate

The supply of a currency increases when:

Citizens import more foreign goods and services
Tourists travel abroad and need foreign currency
Investors send money abroad
Speculators sell the currency expecting it to fall in value

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 Your notes

The relationship between the US$ and the Euro shows that as Europeans demand the $ it
appreciates but by supplying their own currency it depreciates

Diagram analysis
The Euro/US$ market is shown by two market diagrams - one for the USD market on the
left and one for the Euro market on the right
The initial exchange rate equilibrium is found at P1Q1 in both markets
When Europeans visit the USA, they demand US$ and supply Euros
The increased demand for the US$ shifts the demand curve to the right, which
results in the value of the $ appreciating from P1 → P2 in the USD market and a new
market equilibrium forms at P2Q2
The increased supply of the Euro shifts the supply curve to the right which results in
the value of the Euro depreciating from P1 → P2 and a new market equilibrium forms
at P2Q2

Causes of foreign exchange rate

fluctuations
Several factors cause exchange rates to change. Three of the most common include:

Cause Explanation

Changes in demand for If a country’s exports rise, demand for its currency
exports and imports increases, causing appreciation
If imports rise, more of the home currency is sold to buy
foreign currency, leading to depreciation

Changes in interest rates Higher interest rates attract foreign savers and investors,
increasing demand for the currency and causing it to
appreciate

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 Lower interest rates tend to reduce demand and cause
depreciation
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Speculation If traders believe a currency will rise in value, they buy

more of it, which increases demand and causes
appreciation
If they expect it to fall, they sell the currency, increasing
supply and causing depreciation

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 Consequences of Changes in Foreign Exchange Rates
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What happens when exchange rates

change?
A change in the exchange rate affects the relative price of domestic and foreign goods. This
influences how much consumers and firms buy and sell internationally.
If the currency appreciates (gets stronger), exports become more expensive for other
countries, and imports become cheaper for domestic consumers
If the currency depreciates (gets weaker), exports become cheaper, and imports
become more expensive

Effects of currency appreciation

Impact Area Effect of appreciation

Exports Become more expensive to foreigners → demand falls

Imports Become cheaper → demand rises for foreign goods

Domestic firms Exporters may lose customers; less revenue from overseas
sales

Consumers Benefit from cheaper imported goods and foreign travel

Inflation Likely to fall as imported goods are cheaper and reduce cost
pressures

Balance of May worsen if exports fall and imports rise, increasing the
Payments Current Account deficit

Effects of currency depreciation

Impact area Effect of depreciation

Exports Become cheaper to foreigners → demand increases

Imports Become more expensive → demand falls for foreign goods

Domestic firms Exporters benefit from higher sales → more output and
possibly more jobs

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 Consumers Face higher prices for imported goods such as electronics and
fuel
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Inflation Likely to rise as cost of imported goods and raw materials
increases

Balance of May improve if exports rise and imports fall, reducing the
Payments Current Account deficit

Case Study
The UK Pound Depreciation After the 2016 Brexit Vote
In June 2016, the UK voted to leave the European Union (Brexit). As a result, there was
major uncertainty in financial markets, and the value of the British pound (GBP) fell
sharply against other major currencies.
Before the referendum: £1 ≈ $1.45
After the vote: £1 fell to ≈ $1.20 — a 17% depreciation
This depreciation affected trade, consumer prices, and the wider economy.

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Impact
The weaker pound had the following effects: Your notes
Exports became cheaper for foreign buyers
British-made goods and services were more affordable abroad
Imports became more expensive
The UK had to pay more for imported products like fuel, food, and
electronics
UK firms saw a rise in overseas demand but also higher input costs for imported
raw materials
Consumers in the UK faced rising prices for everyday items due to more
expensive imports
Macroeconomic result
UK exporters benefited, especially in manufacturing and tourism, as foreign
customers took advantage of favourable exchange rates
Inflation rose in 2017, peaking at 3%, partly due to the higher import costs
The Current Account deficit narrowed slightly, helped by stronger exports and
weaker import growth
Consumers faced reduced purchasing power, especially for imported goods,
leading to pressure on real incomes and the standard of living

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