IGCSE Economics Notes / Foreign Exchange Rates

6.3.1 Definition of foreign exchange rate

• A foreign exchange rate is the price of one currency in terms of another currency
• It shows how much of one currency can be exchanged for another

6.3.2 Reasons for buying and selling foreign currencies

• Trade in goods and services: exporters and importers exchange currencies to pay for international trade
• Speculation: traders buy or sell currencies expecting future changes in exchange rates to make profit
• Government intervention in currency markets: governments may buy or sell currency to influence exchange rates
• Payment of profit, interest and dividends between countries
• Workers’ remittances sent back to home countries
• Investment in capital goods and foreign direct investment between countries

6.3.3 Determination of foreign exchange rate in foreign exchange market

Key definitions

• Floating exchange rate: exchange rate determined by market forces of demand and supply without direct government control
• Appreciation: increase in value of a currency relative to others
• Depreciation: decrease in value of a currency relative to others

Demand and supply of a currency

• Demand for a currency arises from demand for exports, investment inflows, tourism and speculation
• Supply of a currency arises from imports, investment outflows, tourism abroad and selling currency for other currencies

Equilibrium exchange rate

• The equilibrium foreign exchange rate is determined where demand and supply of a currency are equal
• If demand for a currency rises, its value appreciates
• If supply of a currency rises, its value depreciates

Causes of foreign exchange rate fluctuations

• Changes in demand for exports and imports affect currency demand and supply
• Changes in interest rates attract or discourage foreign investment affecting exchange rate
• Speculation based on expectations of future exchange rate movements

6.3.4 Consequences of changes in foreign exchange rates

• Appreciation makes exports more expensive and imports cheaper, reducing export demand but increasing import demand
• Depreciation makes exports cheaper and imports more expensive, increasing export demand but reducing import demand
• Changes in exchange rates affect prices of imported goods, inflation and international competitiveness
• A depreciation may increase export revenue but increase cost of imported raw materials
• An appreciation may reduce inflation but harm domestic producers due to cheaper imports