International Trade and Globalisation – Foreign‑Exchange Rates
1. Syllabus‑Alignment Checklist (Cambridge IGCSE 0455 / A‑Level Economics)
| Syllabus Requirement |
Current Coverage |
Action‑oriented Improvements |
| 6.3 Foreign‑exchange rates – definition |
Definition present, includes both quotation methods. |
Insert the exact Cambridge wording: “the price of one currency expressed in terms of another”. |
| Reasons for buying/selling foreign currency (trade, speculation, government intervention, profit/interest/dividend payments, remittances, capital‑goods investment) |
All motives listed in a table, but wording can be tighter and include brief examples. |
Revise the table with concise definitions and a short illustrative example for each motive. |
| 6.4 Exchange‑rate regimes – floating, managed float, fixed |
Regimes described, but could emphasise the link to market forces. |
Add a one‑sentence note on how each regime affects the impact of export‑ and import‑demand on the rate. |
| 6.5 How changes in export and import demand affect FX rates |
Export‑ and import‑demand effects explained with arrows. |
Re‑format using clear sub‑headings, include a supply‑and‑demand diagram description, and add a short “step‑by‑step” flow for each effect. |
| 6.6 Consequences of FX‑rate movements (competitiveness, import prices, inflation, balance of payments) |
Covered in bullet points. |
Group consequences under the three AO2 headings used in exams and add a brief exam‑style cue. |
| 6.7 Current account and its relation to FX rates |
Current account explained. |
Highlight the link: surplus → upward pressure on domestic currency; deficit → downward pressure. |
| Real‑world examples & practice questions |
One example (oil boom) and one practice question. |
Provide a second, contrasting example (tourism surge) and ensure the practice question follows the “explain” format required by the syllabus. |
2. Definition of a Foreign‑Exchange Rate
- Foreign‑exchange rate (FX rate): the price of one currency expressed in terms of another (Cambridge exact phrasing).
- Two common quotation conventions:
- Domestic‑per‑foreign (e.g. £/$ = 0.80 £ per $1) – amount of domestic currency needed to buy one unit of foreign currency.
- Foreign‑per‑domestic (e.g. $/£ = 1.25 $ per £1) – amount of foreign currency obtained for one unit of domestic currency.
3. Why Economic Agents Buy or Sell Foreign Currency
| Motivation | What the agent does | Typical example |
|---|
| Trade in goods and services |
Buy foreign currency to pay for imports; sell foreign currency to receive payment for exports. |
UK importer purchases Chinese electronics → converts pounds into yuan. |
| Speculation |
Buy a currency expecting it to appreciate, or sell expecting depreciation. |
Trader buys euros anticipating a rise after ECB policy change. |
| Government/central‑bank intervention |
Buy or sell foreign currency to influence the market or defend a peg. |
Swiss National Bank purchases francs to curb appreciation. |
| Profit/interest/dividend payments |
Foreign investors convert domestic currency to remit interest, dividends, or profits. |
Japanese investor converts yen into dollars to receive US dividend. |
| Remittances |
Workers abroad convert earnings into the home‑country’s currency. |
Mexican migrant in the US sends dollars home, exchanged for pesos. |
| Capital‑goods investment (FDI) |
Foreign firms exchange their currency for the host‑country’s currency to buy machinery or set up plants. |
German carmaker purchases Indian rupees to build a factory. |
4. Exchange‑Rate Regimes
- Floating (flexible) rate: The FX rate is set entirely by market supply and demand.
- Managed float (dirty float): Mostly market‑driven, but the central bank intervenes occasionally to smooth excessive volatility.
- Fixed (pegged) rate: The government or central bank commits to a specific rate and stands ready to buy/sell foreign currency to maintain it.
Even under a fixed regime, export‑ and import‑demand create *pressure* on the peg; persistent pressure may force a re‑valuation, de‑valuation, or a change of regime.
5. How Trade Demand Affects the FX Rate
5.1 Export‑Demand Effect
- Foreign buyers want more of the home country’s goods/services.
- To pay, they must obtain the home country’s currency.
- Demand for the domestic currency rises → the demand curve in the FX market shifts right.
- Result: appreciation** of the domestic currency** (domestic‑per‑foreign rate falls, foreign‑per‑domestic rate rises).
5.2 Import‑Demand Effect
- Domestic residents increase purchases of foreign goods/services.
- They exchange domestic currency for the foreign currency of the goods they buy.
- This adds to the supply of the domestic currency in the FX market → supply curve shifts right.
- Result: depreciation** of the domestic currency** (domestic‑per‑foreign rate rises, foreign‑per‑domestic rate falls).
5.3 Diagrammatic Summary
Imagine a standard supply‑and‑demand graph for the domestic currency:
- Vertical axis: “FX rate (domestic‑per‑foreign)”.
- Horizontal axis: “Quantity of domestic currency”.
- Right‑ward shift of the demand curve (export growth) moves the equilibrium leftward → lower FX rate (appreciation).
- Right‑ward shift of the supply curve (import growth) moves the equilibrium rightward → higher FX rate (depreciation).
6. Combined Effect of Export and Import Demand
| Change in Trade Demand |
Net Effect in the FX Market |
Resulting FX‑Rate Movement |
| Export demand ↑, import demand unchanged |
Demand curve for domestic currency shifts right |
Appreciation (domestic‑per‑foreign rate falls) |
| Import demand ↑, export demand unchanged |
Supply curve for domestic currency shifts right |
Depreciation (domestic‑per‑foreign rate rises) |
| Both export and import demand ↑, export growth > import growth |
Net right‑ward shift of demand exceeds supply shift |
Appreciation, but magnitude depends on relative sizes |
| Both export and import demand ↓, import decline > export decline |
Net left‑ward shift of supply exceeds demand shift |
Appreciation (fewer domestic units offered) |
7. Consequences of FX‑Rate Movements (AO2 – exam focus)
- Export competitiveness – An appreciation makes domestic goods more expensive for foreign buyers, reducing export volumes; a depreciation does the opposite.
- Import prices and consumer spending – Depreciation raises the domestic price of imports, potentially lowering import volumes and reducing real disposable income; appreciation makes imports cheaper.
- Inflation and the balance of payments – Higher import prices can generate cost‑push inflation; changes in export/import values affect the current‑account balance (surplus ↔ upward pressure on the currency, deficit ↔ downward pressure).
8. Current Account and Its Link to the FX Rate
The current account records all transactions that involve the exchange of goods, services, primary income (interest, dividends, profits) and secondary income (remittances, gifts). Its relevance to FX rates:
- Surplus → foreign buyers need the domestic currency → upward pressure → appreciation.
- Deficit → domestic residents need foreign currency → downward pressure → depreciation.
9. Real‑World Illustrations
9.1 Oil‑Export Boom (appreciation pressure)
- Country A’s oil price spikes → foreign demand for its oil surges.
- Foreign purchasers must obtain Country A’s currency → demand curve for the currency shifts right.
- The domestic currency appreciates, making non‑oil exports relatively more expensive.
- Higher domestic incomes increase demand for imported smartphones → supply of the domestic currency rises, partially offsetting the appreciation.
9.2 Tourism Surge (appreciation with a small offset)
- Country B experiences a sudden rise in overseas tourists.
- Tourists need Country B’s currency to pay for hotels, meals, attractions → export‑demand effect → currency appreciates.
- Many tourists also buy locally‑made souvenirs that are imported (e.g., foreign‑made chocolates), creating a modest increase in import demand → a slight supply‑side pressure.
- Net result: a noticeable appreciation, slightly moderated by the import component.
10. Key Points to Remember (Exam Checklist)
- Export‑demand ↑ → higher demand for domestic currency → appreciation.
- Import‑demand ↑ → higher supply of domestic currency → depreciation.
- The overall FX movement depends on the *relative* size of the two forces.
- FX‑rate changes feed back into export competitiveness, import prices, inflation and the current‑account balance.
- Even under a fixed regime, persistent export‑ or import‑demand pressures can force a re‑valuation, de‑valuation, or a shift to a different regime.
11. Practice Question (AO2)
Question: Country X experiences a sudden increase in tourism from abroad. Explain, using the concepts above, how this will affect the exchange rate of Country X’s currency, assuming no other changes.
Answer Outline
- More tourists mean higher demand for Country X’s goods and services → an increase in export demand.
- Tourists must obtain Country X’s currency to pay for hotels, meals, attractions, etc.; therefore the demand for the domestic currency rises.
- In the short run the supply of the currency is unchanged, so the demand curve shifts right.
- The new equilibrium shows a lower domestic‑per‑foreign rate – i.e., the domestic currency appreciates.
- Possible nuance: tourists also buy imported souvenirs, creating a small increase in supply of the domestic currency that could partially offset the appreciation, but the net effect remains an appreciation.