Exchange Rates – AS/A LEVELS/IB/IAL

Exchange Rates – AS/A LEVELS/IB/IAL

Courses Info

Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas – Economics Revision Notes 

Exchange Rates

The exchange rate is the rate at which one currency exchanges for another e.g. £1 = $2. 

Exchange Rate Systems


The exchange rate is determined by market forces of supply and demand.


This is when a country’s currency is fixed against a currency of another country. The most commonly used currency to fix against is the Dollar.


This exchange rate system is a floating exchange rate system but is subject to intervention by central banks.

Exchange Rate – Key Terms


This occurs when a country decides to increase the exchange rate of its currency under a fixed exchange rate


This refers to an increase in the value of a country’s exchange rate under a floating exchange rate. 


This occurs when a country decides to decrease the exchange rate of its currency under a fixed exchange rate.


This refers to a decrease in the value of a country’s exchange rate under a floating exchange rate. 

What factors influence exchange rates?

Interest Rates

If interest rates are high this will increase the demand for the pound causing the value of the pound to increase. 

Inflation rates

If there is an increase in the inflation rate in the UK. This would make UK goods and services less competitive. This would cause a decrease in demand for the pound leading to a fall in the value of the currency.

Current Account Balance of Payments (BOP)

A persistent deficit on the BOP on the current account means there is excess supply over demand of the currency leading to a fall in the value of the pound.

Foreign Direct Investment (FDI)

If the UK has more inflows of FDI than outflows than it would be a net recipient. Therefore the demand for the UK pound would increase causing the value of the pound to rise.

Speculation/State of the economy

Speculation can occur due to a variety of factors such as the state of the economy. During the Coronavirus pandemic, the demand for the currency reduced as there was less confidence in the country.

Political factors

Political instability due to war, famine, corruption, Brexit can cause uncertainty and instability in a country. This will cause a decrease in demand and the value of the currency.

Government Intervention in Currency Markets

Interest Rates

The government can use interest rates to increase or decrease the demand for their currency

Higher Interest Rates – this will increase the demand for the Pound as it strengthens and more people will convert their money to pounds

Lower Interest Rates – this will reduce the demand for the Pound as it weakens and more people will keep their money in a different currency which offers more value for their money

Gold and Foreign Currency Reserves

Governments can use Gold and Foreign Currency Reserves to manipulate the value of their currency.

If value of the pound is too high – they can increase the supply of buying foreign currency or gold to weaken the value of the pound

If value of the pound is too low – they can increase the demand by selling their foreign currency or gold to strengthen the value of the pound

Competitive devaluation / depreciation

A country recognises the need to drive down the value of their currency and therefore intervenes in foreign exchange markets to create a competitive boost for their exporting industries

Weaker Currency – will encourage exports and discourage imports, improving the balance of payments. However, this may lead to inflation and reduce competitiveness

Impact of changes in exchange rates

Current Account of BOP

  • The Marshall-Lerner condition – for a currency devaluation to have a positive impact on the trade balance, the sum of the elasticities of imports and exports must be elastic
  • J Curve – this shows how the current account will worsen before it improves
  • Rate of Inflation – imports become more expensive, causing prices to rise, if there is a fall in the exchange rate
  • FDI – FDI may increase due to the cost of investing becoming cheaper, as a result of a fall in the currency
  • Economic Growth and Unemployment – exports are likely to increase as they become cheaper due to a weaker exchange rate

AQA Spec – Additional Content

Advantages & Disadvantages of a Fixed and Floating Exchange Rate

Fixed Exchange Rate


  • Allows firms to plan ahead in advance for investment opportunities, without worrying about harsh fluctuations in the exchange rate
  • Provides a focused target that the Monetary Policy can work towards


  • It may be the case that the government and the central bank do not know better than the market about where the currency should be
  • The BOP does not adjust automatically to economic shocks
  • If the government were to hold large reserves of foreign currencies, it can be costly

Floating Exchange Rate


  • The exchange rate can adjust to economic shocks automatically
  • More freedom for the Monetary Policy


  • The fluctuations in the exchange rate can be unpredictable
  • Can cause unemployment if there are drastic changes in the levels of exports / imports
  • Exchange Rate can be vulnerable to speculative shocks

Advantages and Disadvantages for a country joining a currency union

In a monetary union, countries share the same currency – and example of this is The Eurozone

When a monetary union is formed, a common central monetary policy is established

The same interest rate is also used amongst monetary unions


  • The members in the union have more currency stability and are at less risk to speculative shocks – future markets gain more certainty, so there is more investment and growth potential
  • When travelling abroad or exchanging money, there are less admin fees / red tape
  • It is also beneficial for firms which trade with countries of the same currency as it is cheaper and less time consuming


  • Language barriers create a limited labour mobility across countries in Europe
  • A common monetary policy may not be effective due to the differences on economic performance between member countries
  • It is difficult for the exchange rate to change in accommodation of each country’s needs
  • When there is a common monetary union, member countries with stronger economies lose some of their sovereignty to member countries with weaker economies
  • The one-off cost of joining a currency union can be expensive


Quick Fire Quiz – Knowledge Check

1. Define ‘Exchange Rate’ (2 marks)

2. Identify the three Exchange Rate Systems (3 marks)

3. Distinguish between a ‘Revaluation’ and ‘Devaluation’ (4 marks)

4. Distinguish between an ‘Appreciation’ and ‘Depreciation’ (4 marks)

5. Identify and explain six factors which influence exchange rates (12 marks)

6. Identify and explain two forms of government intervention in currency markets (6 marks)

7. Explain what is meant by a competitive devaluation / depreciation (4 marks)

8. Identify and explain fie impacts of changes in exchange rates (10 marks)


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