Exchange rates

Economics AS · International economic issues. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

An exchange rate is the price of one currency in terms of another. A floating exchange rate is set by the demand for and supply of the currency on the foreign exchange market, with no government target.

Foreigners demand the currency to buy the country's exports, to invest there or to save in its banks. Residents supply the currency when they buy imports or invest abroad. More demand or less supply causes an appreciation (the currency buys more foreign currency). Less demand or more supply causes a depreciation.

A depreciation makes exports cheaper abroad and imports dearer at home. Net exports tend to rise, so AD shifts right. Dearer imported raw materials raise costs, so SRAS shifts left. An appreciation has the opposite effects.

Rules to remember

Exchange rate = the price of one currency in terms of another currency.
Floating rate: determined by demand for and supply of the currency.
Demand for a currency comes from exports, inward investment, foreign tourists and savings attracted by high interest rates.
Supply of a currency comes from imports, investment abroad and residents travelling abroad.
Appreciation: one unit of the currency buys more foreign currency. Depreciation: it buys less.
Depreciation: exports cheaper, imports dearer; AD shifts right if demand is price elastic; SRAS shifts left; the price level tends to rise.
Appreciation: exports dearer, imports cheaper; AD shifts left; SRAS shifts right; the price level tends to fall.

Common mistake

Read the quotation carefully. If the rate moves from $1 = 100 rupees to $1 = 120 rupees, the rupee has depreciated, because more rupees are now needed to buy one dollar. The bigger number does not mean a stronger rupee.

Worked example

The exchange rate changes from £1 = $1.25 to £1 = $1.50. A British firm sells a bicycle for £200. What happens to the pound and to the dollar price of the bicycle?

One pound now buys $1.50 and not $1.25, so the pound has appreciated against the dollar.
Dollar price before = 200 × 1.25 = $250.
Dollar price after = 200 × 1.50 = $300.
Rise in the dollar price = 300 − 250 = $50, which is 50 ÷ 250 × 100 = 20%.

Answer: The pound has appreciated and the bicycle's price in the USA rises from $250 to $300, so British exports become less competitive.

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