Cambridge Syllabus Notes

Exchange‑Rate Regimes (Cambridge AS & A Level)

An exchange‑rate regime describes how a country determines the value of its currency relative to other currencies. The three regimes required by the syllabus are:

Fixed (pegged) rate – the central bank commits to buying and selling the domestic currency at a predetermined rate against a single foreign currency or a basket of currencies.
Floating (flexible) rate – the market determines the exchange rate; the central bank intervenes only to smooth excessive volatility.
Managed (or “dirty”) float – a floating rate with occasional official interventions to influence the rate, usually to achieve external‑balance or inflation targets.

Why the Regime Matters

It determines the nominal exchange rate that appears in the Balance of Payments (BoP).
It shapes the relationship between the real exchange rate and the underlying price levels (PPP).
It influences the tools available for policy coordination (monetary, fiscal, supply‑side).
It affects the credibility of the government and the likelihood of speculative attacks.

Revaluation and Devaluation under a Fixed Peg

Definitions (AO1)

Revaluation: an official upward adjustment of the domestic currency’s value; the peg is set at a stronger rate (fewer domestic units per unit of foreign currency).
Devaluation: an official downward adjustment of the domestic currency’s value; the peg is set at a weaker rate (more domestic units per unit of foreign currency).

Both are policy‑driven moves, not market‑driven fluctuations.

Motives for Adjusting the Peg (AO2)

Revaluation – Typical Motives	Devaluation – Typical Motives
Rapid inflation eroding the real value of the currency. Large current‑account surpluses indicating excessive export competitiveness. Strong capital inflows that push up demand for domestic assets.	Persistent current‑account deficits and depletion of foreign‑exchange reserves. Domestic recession with high unemployment; a weaker currency can boost export demand. Speculative attacks that threaten the sustainability of the existing peg.

Mechanism of Adjustment (AO2)

Step	Revaluation	Devaluation
1. Central‑bank operation	Sells foreign reserves and buys domestic currency → domestic money supply contracts.	Sells domestic currency (or buys foreign reserves) → domestic money supply expands.
2. Official announcement	New, stronger rate (e.g., 1 USD = 8 X instead of 10 X).	New, weaker rate (e.g., 1 USD = 12 X instead of 10 X).
3. Supporting policy tools	Often higher interest rates to reinforce the appreciation and curb capital outflows.	Often lower interest rates to stimulate domestic demand and complement the weaker rate.

Impact on the Balance of Payments (AO2)

Current account
- Revaluation: imports become cheaper, exports more expensive → import volume ↑, export volume ↓ → current‑account deficit pressure.
- Devaluation: exports become cheaper, imports more expensive → export volume ↑, import volume ↓ → current‑account surplus pressure (provided the Marshall‑Lerner condition holds).
Capital account
- Revaluation may attract short‑term capital inflows (higher returns on domestic assets) but can also trigger outflows if investors expect a future reversal.
- Devaluation can provoke capital flight, especially if the peg is perceived as unsustainable; however, lower interest rates may partially offset outflows.
Overall BoP balance – the net effect is the sum of the current‑ and capital‑account changes. A well‑timed adjustment can restore external balance, but credibility and expectations are crucial.

Short‑Run vs Long‑Run Economic Effects (AO2‑AO3)

Revaluation

Imports become cheaper → import volume rises; consumer welfare improves.
Exports become more expensive → export volume falls; export‑oriented firms may cut output and lay off workers.
Domestic inflation tends to fall because cheaper imports reduce cost‑push pressures.
Aggregate demand (AD) may shift leftward (reduced export demand) while AD‑shifts from cheaper imports are ambiguous.
Long‑run impact depends on price‑elasticities; if export demand is inelastic, the current‑account may not improve, and the economy could suffer a “real‑appreciation” problem.

Devaluation

Exports become cheaper → export volume rises; export‑oriented sectors expand, boosting employment.
Imports become more expensive → import volume falls; domestic consumers face higher prices.
Domestic inflation may increase because higher import prices feed through to consumer goods (import‑price pass‑through).
Aggregate demand (AD) typically shifts rightward via export boost, but the price‑level effect may offset part of the AD increase.
Long‑run impact hinges on the Marshall‑Lerner condition (|ε_X| + |ε_M| > 1). If the condition fails, the devaluation can worsen the current‑account.

J‑Curve Effect

After a devaluation, the current‑account may initially deteriorate because contracts and import‑price elasticities are sticky (the “J‑curve”). Over time, as quantities adjust, the current‑account improves. A simple diagram can be drawn with time on the horizontal axis and current‑account balance on the vertical axis, showing a dip followed by a rise.

Real vs Nominal Exchange Rate & Purchasing‑Power Parity (AO1)

Nominal exchange rate (E): the quoted price of foreign currency in domestic units (e.g., 1 USD = 10 X).
Real exchange rate (R): adjusts the nominal rate for price level differences:
$$R = E \times \frac{P_{\text{dom}}}{P_{\text{for}}}$$ where $P_{\text{dom}}$ and $P_{\text{for}}$ are the domestic and foreign price indices.
PPP (long‑run equilibrium): when $R = 1$; deviations signal over‑ or undervaluation.

Policy Coordination (AO3)

Monetary policy – interest‑rate changes reinforce the peg (higher rates for revaluation, lower rates for devaluation).
Fiscal policy – a contractionary fiscal stance (lower deficit) can support a revaluation by reducing pressure on reserves; expansionary fiscal policy may be needed after a devaluation to boost demand.
Supply‑side measures – improving productivity can offset the inflationary impact of a devaluation.
Exchange‑rate and capital‑flow management – capital controls, reserve requirements, or macro‑prudential tools can help maintain credibility.

Credibility, Speculative Attacks and Case Study (AO3)

When markets doubt a government’s ability or willingness to maintain a peg, they may launch a speculative attack, selling domestic currency for foreign reserves. A classic example is the 1992 ERM crisis, where the British pound was forced to devalue (and eventually exit the Exchange‑Rate Mechanism) after massive speculative pressure.

Key lesson: credibility is as important as the size of the adjustment.
Frequent or large adjustments erode confidence, increase the cost of defending the peg, and can precipitate a balance‑of‑payments crisis.

Exchange‑Rate Regimes in Developing Economies (AO2)

Many low‑income countries adopt a fixed peg or a managed float to import price stability and anchor inflation expectations.
Fixed pegs can reduce “exchange‑rate risk” for trade and attract foreign direct investment, but they require substantial foreign‑exchange reserves.
Managed floats allow limited flexibility to respond to shocks while retaining some stability.

Illustrative Numerical Example (LaTeX)

Assume a country pegs its currency at E₀ = 5 domestic units per US $. A 20 % devaluation changes the peg to:

$$ E_{1}=E_{0}\times(1+0.20)=5\times1.20=6\ \text{domestic units per US\$} $$

A laptop priced at US $800 would cost:

$$ \text{Before devaluation: } 800\times5=4\,000\ \text{units} $$ $$ \text{After devaluation: } 800\times6=4\,800\ \text{units} $$

The same laptop becomes 20 % more expensive for domestic consumers, illustrating the inflationary pressure that can follow a devaluation.

Suggested Diagrams (Exam‑Ready)

Foreign‑exchange market (supply & demand) – vertical axis = exchange rate (domestic per foreign); horizontal axis = quantity of foreign currency. Show:
- Initial equilibrium E₀ where supply of reserves (S₀) meets demand (D₀).
- Devaluation: shift supply rightward (or demand leftward) to a higher rate E₁.
- Revaluation: shift supply leftward (or demand rightward) to a lower rate E₁.
- Label central‑bank intervention (buying/selling reserves).
J‑curve diagram – time on the x‑axis, current‑account balance on the y‑axis. Show an initial dip after a devaluation followed by a gradual rise.
Marshall‑Lerner condition – a simple graph with export‑price elasticity on the x‑axis and import‑price elasticity on the y‑axis; the line ε_X + ε_M=1 separates the region where a devaluation improves the current‑account (above the line) from the region where it worsens it (below the line).

Link to Other Syllabus Areas (AO2)

Balance of Payments (Unit 11) – direct impact on current‑ and capital‑account components.
Aggregate Demand & Supply (Unit 9) – export/import changes shift AD; price‑level effects feed into AS.
Monetary Policy (Units 9.3‑9.4) – interest‑rate adjustments used to reinforce the peg.
Government Intervention (Units 8.1‑8.2) – evaluation of the effectiveness, equity and distributional consequences of exchange‑rate policy.
Development Indicators (Unit 11.5) – small open economies often rely on exchange‑rate policy to achieve growth and inflation targets.

Key Points to Remember (AO1‑AO3)

Both revaluation and devaluation are policy decisions, not market‑driven movements.
They are tools to restore **external balance** and maintain the credibility of a fixed peg.
Short‑run effects on trade volumes are opposite; long‑run outcomes depend on price‑elasticities (Marshall‑Lerner), inflation dynamics, and capital‑flow responses.
Frequent adjustments can undermine confidence, increase speculation, and potentially lead to a BoP crisis.
When answering exam questions, always:
1. Define the term clearly.
2. Explain the underlying motives and the central‑bank mechanism.
3. Analyse short‑run and long‑run effects using appropriate diagrams (FX market, J‑curve, AD/AS).
4. Evaluate advantages and disadvantages, referencing key assumptions (price‑elasticities, capital mobility, credibility).

Common Misconceptions (AO3)

“A devaluation always improves the trade balance.” – Only if the sum of export‑ and import‑price elasticities exceeds one (Marshall‑Lerner condition).
“Revaluation eliminates inflation.” – It can reduce import‑price inflation, but domestic cost‑push factors may remain.
“The market decides the peg.” – Under a fixed regime the official rate is set by the government; market pressure matters only when the peg becomes unsustainable.

distinction between revaluation and devaluation of a fixed exchange rate