Exchange Rates

Exchange rate. The price of one currency expressed in terms of another.

e.g., £1 = $1.25 (the pound is worth$1.25).

Conversion:

• Amount in foreign currency = amount in home currency × exchange rate.
• £100 at £1 = $1.25 →$125.

Read carefully. Quotes can be either direction. £1 = $1.25 is the same as$1 = £0.80. Either expresses the same relative value.

Exchange rates can be:

• BILATERAL (one currency vs another).
• EFFECTIVE / TRADE-WEIGHTED (one currency vs a basket of trading partners — gives a single 'overall' value).

Cambridge tip. Mark schemes for currency-conversion questions reward 1 mark for the formula + 1 for the calculation. Show working.

The SPICED mnemonic is the most-tested concept in exchange-rate questions.

SPICED (Strong Pound = Imports Cheaper, Exports Dearer).

When the home currency APPRECIATES:

• Home currency buys MORE foreign currency.
• IMPORTS become cheaper in home-currency terms (consumers benefit).
• EXPORTS become more expensive in foreign-currency terms (foreign buyers see them as costlier).

Effects on the economy:

Channel	Direction
Imports	Cheaper → import volume rises
Exports	Pricier → export volume falls
Inflation	Falls (cheap imports + lower demand)
Trade balance	Worsens (more imports, fewer exports)
Domestic firms	Hurt (lose price advantage abroad)
Domestic consumers	Helped (cheap imports)

WPIDEC (Weak Pound = Imports Dearer, Exports Cheaper).

When the home currency DEPRECIATES — opposite of all the above:

• Imports get more expensive → inflation pressure.
• Exports cheaper for foreign buyers → demand for them rises.
• Trade balance improves.
• Domestic firms benefit; consumers hurt by inflation.

Worked application. UK pound depreciates from £1=$1.40 to £1=$1.20.

• A US firm previously paying $1.40 for £1 of UK goods now pays$1.20 — UK exports cheaper for US buyers → UK exports rise.
• A UK consumer previously paying £1 for $1.40 of US goods now pays £1 for only$1.20 — US imports more expensive for UK buyers → UK imports fall.
• UK trade balance improves.

Cambridge tip. Mark schemes consistently use the SPICED framework. Memorise it. Apply it to any appreciation/depreciation question.

Floating exchange rate system.

The exchange rate is determined by SUPPLY AND DEMAND for the currency in foreign exchange markets.

• Most major currencies (USD, GBP, EUR, JPY) float.
• The rate moves continuously as traders buy and sell.

Advantages:

• Automatic adjustment to shocks (e.g., a weakening currency boosts exports).
• No need for large foreign-exchange reserves.
• Allows independent monetary policy.

Disadvantages:

• Volatility — rates can swing significantly, complicating trade.
• Speculation can drive movements unrelated to fundamentals.
• Less price predictability.

Fixed exchange rate system.

The exchange rate is SET by the government / central bank at a specific level. Maintained by:

• Central bank intervention (buying/selling currency reserves).
• Capital controls (restricting cross-border money flows).

Examples: China's managed yuan; Saudi Arabia's pegged riyal; Hong Kong's pegged dollar.

Advantages:

• Stability for trade and investment.
• Predictable prices for imports/exports.
• Anchors inflation expectations.

Disadvantages:

• Requires large reserves to defend the peg.
• Loses monetary policy independence.
• May become unsustainable in a crisis (currency speculators can break a peg — e.g., UK 1992 'Black Wednesday').

Managed (dirty) float. Most real-world floating systems involve OCCASIONAL central bank intervention to smooth volatility. Pure floating without any intervention is rare.

Cambridge tip. Mark schemes for "fixed vs floating" expect both definitions, plus advantages of EACH. Don't favour one over the other.

In a floating system, exchange rates are driven by SUPPLY of and DEMAND for the currency.

Supply of UK pounds increases (depreciation pressure):

• UK importers need to convert pounds into foreign currency to buy imports.
• UK investors buying foreign assets.
• UK tourists travelling abroad.
• Speculation against the pound.

Demand for UK pounds increases (appreciation pressure):

• Foreign buyers need pounds to buy UK exports.
• Foreign investors buying UK assets.
• Foreign tourists visiting the UK.
• Speculation in favour of the pound.

Key determinants:

1. Interest rates. Higher UK interest rates → foreign investors buy UK bonds/deposits → demand for pounds rises → appreciation.

2. Inflation differentials. Higher UK inflation than abroad → UK exports become uncompetitive → demand for pounds falls → depreciation.

3. Economic performance. Strong UK growth → confidence in UK assets → demand for pounds rises.

4. Trade balance. Persistent trade deficit → more pounds supplied (to buy imports) → depreciation pressure.

5. Speculation. Traders' expectations can drive short-term movements, sometimes detached from fundamentals.

6. Political stability. Crisis or instability → capital flight → depreciation.

Cambridge tip. Mark schemes for "determinants of exchange rate" expect 4-5 factors. Top-band candidates link them to supply and demand for the currency.