Key Idea: A pair of trainers on a Japanese website costs 12 000 yen. What you actually pay depends on a price you never see: the price of your currency in yen. That price is the exchange rate. Under a floating rate nobody sets it. Anyone buying a country's exports, investing in it or visiting it has to buy its currency first, and the demand and supply for the currency set the price. Some governments refuse to leave it to the market and fix the rate instead, defending it with reserves and interest rates. When the rate moves, everything traded changes price, so inflation, growth, jobs and the current account move with it. Where you meet it:
Paper 1
- Essays.
- Explain [10]: how a floating rate is determined, two factors behind an appreciation, or floating against fixed.
- Discuss [15]: the consequences of a depreciation or an appreciation, or whether a falling currency cures a deficit.
Paper 2
- Data response, usually with a currency chart.
- Define [2]: depreciation, a floating exchange rate, an overvalued currency.
- Calculate [2]: convert a price or an import bill between currencies, or the percentage change in a rate.
- Explain [4] with an exchange rate diagram: a cause that moves the currency. The most asked question in Unit 4.
The diagram
- One market, and the good being traded is the currency itself.
- The rate goes on the vertical axis, the quantity of the currency on the horizontal.
- Almost every four-mark answer here is one shift and one new crossing.
💱 A currency has a price, and a market sets it
An exchange rate is the price of one currency in terms of another: €1 = US$1.10 means one euro buys 1.10 dollars. Under a floating exchange rate the market sets that price on its own. Everyone who needs the currency demands it, everyone paying for something abroad supplies it, and where the two meet is the rate.
Demand for the currency rises when…: **Foreigners buy more of our exports.** They need our currency to pay for them.. **Foreign firms invest here.** A factory built here or a company bought here is paid for in our currency.. **Our interest rates rise relative to other countries'.** Foreign savers move money in for the better return.. **Tourists visit.** They exchange their own currency for ours before they can spend.. **Traders expect the currency to rise**, so they buy it now..
Supply of the currency rises when…: **We buy more imports.** We sell our currency to pay foreign sellers in theirs.. **Our firms invest abroad.** Building a plant in another country means selling our currency for theirs.. **Our interest rates fall relative to other countries'.** Money leaves for a better return elsewhere.. **We travel abroad.** Holidaymakers sell the currency to spend somewhere else.. **Traders expect the currency to fall**, so they sell it now..
The vertical axis is the exchange rate, written as the price of one unit of your currency in the other one: the price of €1 in US dollars. The horizontal axis is the quantity of that currency, not a quantity of goods. A currency that rises appreciates; one that falls depreciates. In a float nobody decides that: the crossing moves.
📈 What makes a currency rise or fall
Every cause works the same way: it moves the demand curve for the currency, the supply curve, or both, and the crossing moves with it. In an answer, name the cause, say which curve shifts and which way, and then say what the rate does.
| Cause | What shifts, and why | The currency |
|---|---|---|
| Foreign demand for exports rises | D right: foreign buyers must buy the currency to pay for the goods | appreciates |
| Export revenue falls, as when a commodity boom ends | D left: fewer foreign buyers need the currency | depreciates |
| Demand for imports rises | S right: households and firms sell the currency to pay foreign sellers | depreciates |
| A tariff cuts imports | S left: less of the currency is sold to buy foreign goods | appreciates |
| Interest rates rise relative to other countries | D right and S left: foreign money comes in for the return, and domestic money stays | appreciates |
| Domestic inflation is higher than in trading partners | D left and S right: our goods look expensive to them, theirs look cheap to us | depreciates |
| Inward direct or portfolio investment rises | D right: investors buy the currency before they can buy the assets | appreciates |
| Speculators expect a fall | S right: they sell now, and the selling itself brings the fall about | depreciates |
Important: Appreciation and depreciation are market moves in a floating system. Revaluation and devaluation are deliberate changes to a fixed rate, decided by the government or central bank. Using the wrong pair says you are describing the wrong system. Check which system the text is about before you write.
📉 What a change in the rate does to the economy
A depreciation makes exports cheaper abroad and imports more expensive at home. An appreciation does the opposite. Follow that one change through to prices, output, jobs and the current account, and you have the whole of this topic's essay content.
| What it touches | Depreciation (the currency falls) | Appreciation (the currency rises) |
|---|---|---|
| Export prices abroad | cheaper, so foreign buyers order more | higher, so foreign buyers order less |
| Import prices at home | higher, so we buy fewer imports | cheaper, so we buy more imports |
| Current account | improves, if demand for exports and imports responds enough | worsens, for the same reason in reverse |
| Inflation | rises: imported fuel, food and parts all cost more, and stronger net exports add demand on top | falls: cheaper imports take the pressure off prices |
| Growth and jobs | net exports rise, so aggregate demand rises and exporters and tourism take on workers | net exports fall, so growth slows and export jobs are at risk |
| Foreign debt | costs more to repay: each payment abroad takes more of our currency | costs less to repay |
Marshall-Lerner is the condition. A depreciation improves the current account only if the price elasticities of demand for exports and imports add to more than one. The J-curve is the time path. Contracts are already signed and buyers take time to switch, so at first the country pays more for the same imports and the balance gets worse. Only later does it improve. So the answer to does a cheaper currency close the trade gap is: eventually, and only if buyers respond.
📌 When the government sets the rate instead
Under a fixed exchange rate the central bank picks a level, usually against a major currency, and defends it. Under a managed float the rate is mostly left to the market and the bank steps in only when a swing gets extreme. Most large economies run a managed float.
| Feature | Floating | Fixed | Managed |
|---|---|---|---|
| Who sets the rate | the market alone | the central bank picks a peg | the market, with the bank stepping in |
| Day to day | volatile | stable while the peg holds | in between |
| Monetary policy | free to serve inflation and growth at home | tied to defending the peg | mostly free |
| Reserves needed | none | large | some |
| A trade imbalance | corrects itself as the rate moves | needs a devaluation or lower spending at home | partly corrects itself |
| Word for a change | appreciation, depreciation | revaluation, devaluation | both, depending on the cause |
Defending a peg when the currency is pushed below it
- Spot the pressure — Importers and investors are selling the currency, so supply has shifted right and the market rate is being pushed below the peg. Left alone it would depreciate.
- Buy your own currency — The central bank sells foreign reserves and buys its own currency with them. That shifts demand right and lifts the rate back to the peg. It works only while the reserves last.
- Raise interest rates — A higher return attracts foreign savers, who must buy the currency first, so demand shifts right again. The cost is more expensive borrowing for households and firms at home.
- Controls, then the last resort — Capital controls restrict money leaving the country. If the pressure still does not stop, the bank gives the level up and devalues: it sets a new, lower peg.
Spot it → buy your own currency → raise rates → controls, then devalue
Important: Reserves are finite. A central bank defending a rate the market does not believe in can spend everything it holds and lose the peg anyway. And while it defends, interest rates serve the peg and not the economy: rates stay high in a recession, because letting them fall would let the currency go. That trade-off is the evaluation point in every fixed-rate question.
🔢 Doing the sums
Two calculations come up: converting a price from one currency into another, and working out the percentage change in a rate. Both are one line of arithmetic, and the marks go to doing it the right way round.
- the price written in the currency you are starting from
- the price written in the currency you want
- the exchange rate written as: one unit of A buys this many units of B
From the rate to the answer
- Say the rate as a sentence — €1 = US$1.10 means one euro buys 1.10 dollars. Saying it in words stops the two currencies swapping places in your head.
- Decide multiply or divide — Coming from the currency named first, multiply. Going back to it, divide. So €200 × 1.10 = US$220, and US$220 ÷ 1.10 = €200.
- Percentage change, always the same way — (new rate − old rate) ÷ old rate × 100. A minus sign means the currency has lost value against the other one, and that fall is a depreciation.
- Check the size, write the unit — If one currency is worth less than the other, the converted number should come out smaller. Put the currency symbol on the answer and leave the working on the page.
Say the rate → multiply or divide → work it out → check the size
Important: Dividing where you should multiply. Read the rate as a sentence first, then decide. Dividing a percentage change by the new value. The old value always goes underneath.
✍️ Worked examples
The four shapes this topic is asked in, with new scenarios. Try each before opening the plan.
A report describes a country that has let its currency trade freely since 2015. Define the term floating exchange rate.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Now the diagram question, the one this topic is asked most often.
The number of American tourists visiting the euro area rises sharply over one summer. Using an exchange rate diagram, explain the effect on the value of the euro against the US dollar.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Animated graph
Watch the graph build step by step in study mode.
Now the calculation.
A firm in Poland sells a machine for 48 000 zloty. In January the exchange rate is 1 zloty = US$0.25. By December the zloty has fallen and 1 zloty = US$0.20. Calculate the price of the machine in US dollars in January and in December.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
And the essay.
Using real-world examples, discuss the consequences of an appreciation of a country's currency.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
✅ Quick self-check
Tap each card to check yourself.
What goes on each axis of an exchange rate diagram? The exchange rate on the vertical axis, written as the price of one unit of the currency in another one, and the quantity of that currency on the horizontal axis.
Name three things that raise the demand for a country's currency. Foreigners buying its exports, foreign firms investing in it, and higher relative interest rates bringing money in. Tourists arriving and traders expecting a rise also count.
Distinguish depreciation from devaluation. Depreciation is a market-driven fall in a floating rate. Devaluation is a deliberate lowering of a fixed rate by the authorities. The two words belong to different systems.
€1 = US$1.25 and a camera costs €480. What does an American buyer pay? 480 × 1.25 = US$600. The rate is written as one euro in dollars, so multiply.
A currency moves from US$0.80 to US$0.72. What is the percentage change, and what is it called? (0.72 − 0.80) ÷ 0.80 × 100 = −10%. The currency has lost a tenth of its value against the dollar: a depreciation.
How does a central bank stop its currency falling below a peg? It sells foreign reserves and buys its own currency, which shifts demand for it right, and it can raise interest rates to attract foreign money. Reserves are finite, so neither can go on forever.
State the Marshall-Lerner condition. A depreciation improves the current account only if the price elasticities of demand for exports and imports add to more than one.
Why does the current account get worse before it gets better after a depreciation? The J-curve. Contracts are already signed and buyers take time to switch, so at first the country pays more for the same imports. Volumes adjust later, and then the balance improves.
Exam tips
- The vertical axis is the exchange rate and the horizontal is the quantity of the currency, not a quantity of goods. Say which currency in which.
- Name the cause, say which curve shifts and which way, then say what the rate does. All three, every time.
- Appreciation and depreciation belong to a float. Revaluation and devaluation belong to a fixed rate. They are not interchangeable.
- Say the rate as a sentence before calculating: one euro buys this many dollars. Then decide whether to multiply or divide.
- Percentage change is always (new − old) ÷ old × 100, and the answer needs the word depreciation or appreciation next to it.
- Imported inflation is the cost most answers forget. For a country that imports its fuel it can outweigh the gain in exports.
- In a 15-marker, say over what period. A depreciation that looks harmful after six months can look beneficial after two years, because of the J-curve.