An exchange rate (E) is the price of one currency expressed in terms of another. It is normally quoted as the amount of domestic currency required to buy one unit of foreign currency (e.g. £/$, €/£).
1.1 Nominal vs real exchange rates
Nominal exchange rate (E): the market price of the foreign currency in domestic‑currency units.
Real exchange rate (R): the relative price of domestic goods to foreign goods, taking price levels into account.
A trade‑weighted rate aggregates a country’s exchange rates against a basket of its major trading‑partner currencies, weighted by each partner’s share of total trade.
It is usually expressed as an index (base year = 100).
Formula:
$$E_{TW}= \sum_{i=1}^{n} w_i\,E_i$$
where \(w_i\) = proportion of trade with partner i, \(E_i\) = bilateral nominal exchange rate.
Example (UK): if 40 % of trade is with the Eurozone, 30 % with the US, 20 % with Japan and 10 % with the rest of the world, the UK trade‑weighted rate is a weighted average of £/€, £/$ and £/¥.
2. Exchange‑rate systems
Cambridge distinguishes between systems that are policy‑anchored (the authority sets the rate) and those that are market‑driven (the rate is primarily determined by supply and demand). The table below summarises the main regimes, how the rate is set, typical drivers of change, policy tools, and a brief pros‑cons list (AO3).
System
How the rate is set / maintained
Typical drivers of change
Policy tools available
Pros / Cons (summary)
Fixed (Pegged) Exchange Rate
Central bank commits to buying/selling foreign currency at a predetermined parity \(E_{peg}\); the peg is defended with foreign‑exchange reserves.
Changes in demand for foreign currency (capital outflows, import booms) force reserve transactions.
Reserve sales/purchases, interest‑rate adjustments, capital controls, occasional revaluation/devaluation.
+ Exchange‑rate stability → predictable trade and investment.
– Loss of monetary‑policy autonomy; large reserve requirements.
Floating (Flexible) Exchange Rate
Rate is determined entirely by market forces – the intersection of foreign‑exchange supply and demand.
– Complete loss of monetary sovereignty; reliance on external fiscal discipline.
3. Fixed‑rate mechanics – revaluation and devaluation
Revaluation: an official upward adjustment of the peg (domestic currency becomes stronger). Used to combat inflation or to reflect an improvement in the terms of trade.
Devaluation: an official downward adjustment of the peg (domestic currency becomes weaker). Used to restore competitiveness when a persistent trade deficit exists.
Diagram (suggested): Foreign‑exchange market under a fixed peg. The horizontal line at \(E_{peg}\) shows the central bank’s commitment; reserve sales (left shift of supply) or purchases (right shift) keep the market price at the peg.
The central bank announces a central parity \(E_{0}\) and an allowable band, for example \(E_{0}\pm 2\%.\)
If the market rate \(E_{m}\) stays inside the band, the bank does not intervene.
If \(E_{m}\) breaches the band:
\(E_{m} > E_{0}+2\%\) (domestic currency depreciating too fast) → bank sells foreign reserves to buy domestic currency.
\(E_{m} < E_{0}-2\%\) (domestic currency appreciating too fast) → bank buys foreign reserves, injecting domestic currency.
Intervention can be:
Sterilised – offset by open‑market operations so that the domestic money supply is unchanged.
Non‑sterilised – allowing the money supply to expand or contract, reinforcing the exchange‑rate move.
Diagram (suggested): Managed‑float band. The central line is the announced parity \(E_{0}\); the shaded area shows the ±2 % band. Arrows illustrate central‑bank buying (when the rate falls below the lower limit) and selling (when it rises above the upper limit).
The exchange rate is the equilibrium where the supply of domestic currency (people wanting to sell it for foreign currency) equals the demand for domestic currency (people wanting to buy it).
Interest‑rate differentials – capital flows respond to higher returns.
Expectations of future rates – captured by uncovered interest parity:
$$i = i^{*} + \frac{E^{e}-E}{E}$$
where \(i\) and \(i^{*}\) are domestic and foreign interest rates, \(E^{e}\) is the expected future exchange rate.
Because the central bank does not set a target, policy influence is indirect (through interest rates, open‑market operations, or macro‑prudential measures).
Diagram (suggested): Supply‑and‑demand curves in the foreign‑exchange market. The equilibrium point determines the floating exchange rate.
6. Effects of exchange‑rate changes on the external economy (syllabus 11.2.4)
Marshall‑Lerner condition: a depreciation improves the trade balance if the sum of the absolute values of the export‑price elasticity (\(\varepsilon_X\)) and the import‑price elasticity (\(\varepsilon_M\)) exceeds 1:
$$|\varepsilon_X| + |\varepsilon_M| > 1.$$
When this holds, the price effect (imports become more expensive, exports cheaper) outweighs the volume effect.
J‑curve effect: after an initial depreciation, the trade balance may **worsen** before it improves because contracts are sticky and import volumes adjust slowly. Over time, as quantities respond, the balance moves toward the Marshall‑Lerner outcome.
Link to the balance of payments (BoP):
Exchange‑rate movements affect the **current account** through the price‑effect (expenditure‑switching) and the quantity‑effect (expenditure‑reducing).
In a fixed regime, a loss of reserves can lead to a **balance‑of‑payments crisis**; in a floating regime, the exchange rate itself absorbs the external shock.
Sketch of the J‑curve: the vertical axis shows the current‑account balance, the horizontal axis time. After a depreciation the balance first falls (point A) then improves (point B) as elasticities kick in.
7. How exchange rates change under each system – “what‑if” table (inflation shock)
No exchange‑rate adjustment – the foreign currency is fixed.
Fiscal consolidation and structural reforms to boost productivity.
8. Exam‑style checklist (AO1‑AO3)
Identify the exchange‑rate regime being used (fixed, floating, managed float, crawling peg, currency board, dollarisation).
Explain the mechanism that moves the exchange rate under that regime (e.g., reserve sales/purchases, market supply‑demand, band‑triggered intervention).
Analyse the impact of a specific shock (interest‑rate change, inflation, terms‑of‑trade shift, capital‑flow reversal) on the exchange rate.
Discuss the policy tools available to the government/central bank and evaluate their likely effectiveness (pros‑cons, short‑ vs long‑run).
Weigh the advantages and disadvantages of the regime in terms of exchange‑rate stability, monetary‑policy independence, and external vulnerability.
9. Summary
Exchange‑rate regimes fall into two broad categories:
Policy‑anchored – fixed peg, crawling peg, currency board, dollarisation. The authority deliberately sets the rate and bears the burden of defending it.
Market‑driven – floating and managed float. The rate is primarily set by supply and demand, with the central bank intervening only to limit excessive volatility.
The choice of regime determines:
How quickly the exchange rate responds to shocks.
Which economic channels (interest rates, reserves, fiscal policy) are available to stabilise the economy.
The trade‑off between exchange‑rate stability and monetary‑policy independence.
Understanding these mechanisms is essential for analysing balance‑of‑payments problems, inflation transmission, and the scope of monetary policy at A‑Level.
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