IGCSE Economics – Monetary Policy: Changes in Foreign Exchange Rate
Government and the Macro‑economy – Monetary Policy
Objective of this lesson
To understand how monetary policy can be used to influence the foreign exchange rate and, consequently, the wider economy.
Key concepts
Monetary policy – actions taken by the central bank to control the money supply and interest rates.
Foreign exchange (FX) rate – the price of one currency expressed in terms of another.
Depreciation – a fall in the value of the domestic currency.
Appreciation – a rise in the value of the domestic currency.
How monetary policy affects the foreign exchange rate
Interest‑rate adjustments
When the central bank raises interest rates, domestic assets become more attractive to foreign investors.
This increases demand for the domestic currency, leading to appreciation.
Conversely, a cut in interest rates reduces the return on domestic assets, lowering demand for the currency and causing depreciation.
Open market operations (OMO)
Buying domestic government securities injects money into the economy, lowering interest rates and tending to depreciate the currency.
Selling securities withdraws money, raises rates and tends to appreciate the currency.
Reserve requirements
Lowering the reserve ratio frees up more funds for banks to lend, reducing rates and encouraging depreciation.
Raising the reserve ratio does the opposite, supporting appreciation.
Direct foreign‑exchange intervention
The central bank can buy or sell foreign currency in the FX market.
Buying foreign currency (selling domestic) puts downward pressure on the domestic currency (depreciation).
Selling foreign currency (buying domestic) supports the domestic currency (appreciation).
Economic effects of a change in the foreign exchange rate
Effect
Depreciation of Domestic Currency
Appreciation of Domestic Currency
Exports
Become cheaper for foreign buyers → increase
Become more expensive → decrease
Imports
Become more expensive → decrease
Become cheaper → increase
Trade balance (current account)
Improves (if export response > import response)
Worsens (if import response > export response)
Inflation
Upward pressure (cost‑push from pricier imports)
Downward pressure (cheaper imports)
Domestic output (GDP)
Potentially rises via higher net exports
Potentially falls if net exports contract
Illustrative calculation
Assume the exchange rate moves from \$1.20 USD/£ to \$1.30 USD/£ (a depreciation of the pound). If a UK firm sells a product for £100, the revenue in USD changes as follows:
The firm earns $10 more in foreign currency, illustrating the export‑boosting effect of depreciation.
Exchange‑rate regimes and monetary policy autonomy
Floating (flexible) rate – the market determines the rate; the central bank can use interest‑rate policy freely.
Fixed (pegged) rate – the central bank must maintain the target rate, often by intervening in the FX market, which can limit its ability to adjust interest rates.
Managed float – a hybrid where the rate is mostly market‑driven but the central bank steps in occasionally.
Potential trade‑offs
When the central bank changes interest rates to influence the FX rate, other macro‑economic objectives may be affected:
Inflation vs. export competitiveness – Depreciation can raise inflation, forcing the bank to consider whether the export boost outweighs price stability.
Growth vs. financial stability – Low rates stimulate growth but may fuel asset‑price bubbles.
Suggested diagram
Suggested diagram: Supply and demand for foreign exchange showing how a right‑ward shift in demand (e.g., due to higher domestic interest rates) leads to currency appreciation.
Summary checklist
Identify the monetary‑policy tool being used (interest rate, OMO, reserve ratio, direct intervention).
State the expected direction of the exchange‑rate movement (appreciation or depreciation).
Explain the likely impact on exports, imports, inflation and GDP.
Consider the exchange‑rate regime and any constraints it places on policy.