Definition of foreign exchange rate

International Trade and Globalisation – Foreign‑Exchange Rates

Learning objective

Define the foreign‑exchange (FX) rate, explain why agents buy and sell foreign currencies, and describe how the rate is determined and why it fluctuates.

1. Definition of a foreign‑exchange rate

Two quotation conventions are used in the Cambridge syllabus:

• Direct quotation (domestic per foreign) – the usual convention for UK students. $$E_{\text{direct}}=\frac{\text{Domestic‑currency units}}{\text{Foreign‑currency units}}$$ Example: £0.85 / USD means £0.85 for one US $.
• Indirect quotation (foreign per domestic) – the reciprocal of the direct quote. $$E_{\text{indirect}}=\frac{1}{E_{\text{direct}}}=\frac{\text{Foreign‑currency units}}{\text{Domestic‑currency units}}$$ Using the same example, the indirect quote is 1 / 0.85 ≈ 1.176 USD / £.

2. Why do agents buy and sell foreign currencies?

3. Determination of the FX rate in a floating‑rate system

3.1 Floating exchange rate – definition

3.2 Supply‑and‑demand framework

In the foreign‑exchange market the equilibrium rate is where the quantity of a foreign currency that buyers wish to purchase equals the quantity that sellers wish to supply.

• Demand for foreign currency comes from importers, tourists, investors, governments (intervention), etc.
• Supply of foreign currency comes from exporters, foreign investors, central‑bank sales, etc.

3.3 Appreciation and depreciation (direct quotation)

• Appreciation of the domestic currency: the quoted rate (domestic per foreign) falls. Fewer domestic units are needed to buy one foreign unit. In the diagram this is shown by a **right‑ward shift of the demand curve** (or a left‑ward shift of supply).
• Depreciation of the domestic currency: the quoted rate (domestic per foreign) rises. More domestic units are needed to buy one foreign unit. In the diagram this is shown by a **right‑ward shift of the supply curve** (or a left‑ward shift of demand).

4. Causes of FX‑rate fluctuations

Fluctuations arise when any of the factors that shift the supply or demand curves change.

• Changes in demand for imports or exports – e.g., a surge in UK tourism abroad raises demand for foreign currency, pushing the pound down (depreciation).
• Interest‑rate differentials – higher UK rates attract foreign capital, increasing demand for pounds and causing appreciation.
• Speculation and market expectations – rumours of a future policy change can shift demand or supply before the event actually occurs.
• Central‑bank intervention – buying or selling the domestic currency directly changes supply/demand.

5. Numerical examples

5.1 Direct‑quotation example (already in the notes)

Current quote: £0.85 per 1 USD** (direct quotation).

How many US dollars can be bought with £100?

If the pound **appreciates** to £0.80 per 1 USD, the same £100 now buys:

Because the quoted rate fell from 0.85 to 0.80, the pound has become stronger (appreciated), allowing the holder to obtain more dollars.

5.2 Percentage‑change example (AO2 style)

Suppose the exchange rate moves from £0.85 / USD to £0.95 / USD.

• Calculate the % change in the quoted rate:

The quoted rate has risen, so the pound has **depreciated** by 11.8 %.

• What is the percentage change in the amount of dollars that £100 can purchase?

Thus a depreciation of the pound (higher £/USD) reduces the amount of foreign currency that can be bought, illustrating the inverse relationship between the quoted rate and purchasing power.

6. Consequences of FX‑rate changes (ordered as in the syllabus)

1. Prices of imports – a depreciation makes imports more expensive; an appreciation makes them cheaper.
2. Revenue from exports – a depreciation raises export revenue in domestic terms; an appreciation lowers it.
3. Inflation – higher import prices feed into domestic price levels, putting upward pressure on inflation.
4. Returns on foreign investment – changes affect the value of overseas assets when they are converted back into the domestic currency.
5. Speculation – expectations of future moves encourage buying or selling of currencies, which can amplify the original movement.

7. Quick‑reference diagram prompts for exam practice

• Draw supply‑and‑demand curves for a foreign currency. Label the equilibrium exchange rate E.
• Show a **right‑ward shift of demand** → equilibrium moves left, quoted rate falls → domestic currency **appreciates**.
• Show a **right‑ward shift of supply** → equilibrium moves right, quoted rate rises → domestic currency **depreciates**.
• Annotate each shift with a brief cause (e.g., “higher UK interest rates” for demand shift, “increase in UK imports” for supply shift).

8. Summary box