Effects of changes in foreign exchange rates on prices and demand for exports and imports

International Trade & Globalisation – Foreign‑Exchange Rates (IGCSE 0455 6.3)

Learning Objective

Explain how foreign‑exchange (FX) rates are determined, why currencies are bought and sold, and analyse the impact of FX‑rate movements on the prices and quantities of exports and imports, the trade‑balance and the wider macro‑economy.

1. What is a Foreign‑Exchange Rate?

• Foreign‑exchange rate (E): the price of one unit of foreign currency expressed in units of the home currency.
  Example (home = UK, foreign = US): E = £ per $. If E = 0.85, £0.85 buys $1 (or $1 = £0.85).
• The rate can be quoted the other way round (e.g. $/£). The Cambridge syllabus expects the home‑currency‑per‑foreign‑currency convention, which is used throughout these notes.

2. Why Do Economic Agents Buy or Sell Foreign Currency?

Reason (why)	Typical Agent (who)	Example
Importing goods & services	Domestic firms and households	A UK retailer buys $ to pay for US‑made electronics.
Exporting goods & services (receiving payment)	Domestic exporters	A UK software company receives $ from an American client.
Tourism (paying for overseas holidays or receiving foreign tourists’ spending)	Households, tourism firms	British family exchanges £ for € before a holiday in Spain.
Investment abroad (buying foreign assets)	Businesses, investors	A UK pension fund purchases US government bonds.
Repatriating profits/dividends	Foreign subsidiaries, investors	US subsidiary sends $ profits back to its UK parent.
Speculation on future FX movements	Traders, hedge funds	Speculators sell £ today expecting a future depreciation.
Government intervention (e.g., to stabilise the currency)	Central banks, treasury	Bank of England buys £ to support its value.
Remittances from overseas workers	Households	British migrant in Canada sends £ back home.

3. Determination of the FX Rate in a Floating Market

The foreign‑exchange market operates like any other market: the FX rate is the price at which the quantity of foreign currency demanded equals the quantity supplied.

3.1 Supply‑and‑Demand Diagram (exam‑style description)

• Vertical axis: Exchange rate E (£ per $).
• Horizontal axis: Quantity of foreign currency exchanged (units of $).
• Demand for home currency (D): Foreign buyers need the home currency to purchase the home country’s exports, invest there, or spend on tourism.
  Downward‑sloping – a higher E (home currency stronger) makes foreign goods cheaper, reducing foreign demand for the home currency.
• Supply of home currency (S): Domestic residents need foreign currency to import goods, invest abroad, or send money overseas.
  Upward‑sloping – a higher E makes it attractive for domestic agents to sell home currency for foreign currency.
• Equilibrium: The point where D = S determines the market FX rate.

3.2 Factors that Shift the Curves

Factor	Effect on Demand for Home Currency	Effect on Supply of Home Currency
Higher foreign interest rates	↑ (foreign investors want more home currency to invest)	—
Higher home interest rates	—	↑ (domestic savers seek higher‑return foreign assets)
Improving domestic economic outlook	↑ (more foreign demand for exports)	—
Rising domestic inflation	↓ (foreign buyers need more home currency for the same goods)	—
Speculative expectation of future depreciation	↓ (speculators sell home currency now)	↑ (more home currency offered)
Government intervention (e.g., central bank buying home currency)	↑ (artificially raises demand)	↓ (reduces supply)

4. Floating‑Rate Terminology (Home‑Currency Perspective)

• Appreciation: The home currency becomes more valuable relative to the foreign currency – the exchange rate E rises (more £ per $).
  Example: E moves from 0.80 to 0.90 £/$ – one pound now buys more dollars.
• Depreciation: The home currency loses value – the exchange rate E falls.
  Example: E moves from 0.80 to 0.70 £/$ – one pound buys fewer dollars.
• When the home currency appreciates, the foreign currency depreciates, and vice‑versa.

5. How FX‑Rate Changes Affect Prices

Notation (home = UK, foreign = US):

• P_h = price of a good in the home country (in £).
• P^* = price of the same good in the foreign country (in $).
• E = exchange rate (£ per $).

Export price in foreign currency (price that foreign buyers pay):

\[ P_{e}= \frac{P_{h}}{E} \]

Import price in home currency (price that domestic buyers pay):

\[ P_{i}= P^{*}\times E \]

Consequences

• Depreciation (E ↓) → P_e falls (exports become cheaper abroad) and P_i rises (imports become more expensive at home).
• Appreciation (E ↑) → P_e rises and P_i falls.

6. Impact on Quantity Demanded

6.1 Export‑Demand

• Depreciation → lower export price in foreign currency → right‑ward shift of the export‑demand curve → higher quantity exported.
• Appreciation → higher export price → left‑ward shift → lower quantity exported.

6.2 Import‑Demand

• Depreciation → higher import price in home currency → left‑ward shift of the import‑demand curve → lower quantity imported.
• Appreciation → lower import price → right‑ward shift → higher quantity imported.

Diagram suggestions for exam answers

• Export‑demand graph: vertical axis = export price in foreign currency, horizontal axis = quantity exported. Show a right shift (depreciation) and a left shift (appreciation).
• Import‑demand graph: vertical axis = import price in home currency, horizontal axis = quantity imported. Show opposite shifts.

7. Consequences for the Trade Balance and Current Account

1. Trade‑balance effect depends on the price elasticity of export and import demand.
   • If export demand is elastic, a depreciation can raise export revenue enough to improve the trade balance.
   • If import demand is inelastic, the higher import prices may not reduce import volume much, possibly worsening the trade balance even after a depreciation.
2. The current account comprises trade in goods & services, net primary income and net secondary income. FX movements affect the goods‑and‑services component directly and can also alter income flows (e.g., returns on foreign investment).
3. Long‑run macro‑economic effects
   • Sustained depreciation can stimulate export‑led growth, raise employment in export sectors and boost national income.
   • Higher import prices can generate domestic inflation, prompting the central bank to tighten monetary policy.

8. Summary Table

FX‑Rate Change	Export price (foreign currency)	Export demand	Import price (home currency)	Import demand	Likely trade‑balance effect
Depreciation of home currency	↓	↑ (right‑ward shift)	↑	↓ (left‑ward shift)	Improves if export demand is elastic & import demand inelastic; otherwise ambiguous.
Appreciation of home currency	↑	↓ (left‑ward shift)	↓	↑ (right‑ward shift)	May worsen trade balance unless export demand is very inelastic.

9. Exam‑Style Checklist

• Define: foreign‑exchange rate, appreciation, depreciation (using the home‑currency‑per‑foreign‑currency notation).
• List at least three reasons why agents buy or sell foreign currency, giving a brief example for each.
• Explain, with a labelled supply‑demand diagram, how a change in interest rates or expectations shifts the FX rate.
• Show mathematically how a fall in E (depreciation) reduces export price in foreign currency and raises import price in the home currency.
• Link those price changes to shifts in export‑ and import‑demand curves (draw and label one diagram for each).
• Discuss the role of price elasticity in determining the impact on the trade balance and the current account.
• Briefly mention possible macro‑economic consequences (GDP, employment, inflation, monetary policy).
• Use accurate terminology throughout: “exchange rate falls”, “currency depreciates”, “export revenue”, “import expenditure”, “current‑account surplus/deficit”.