Cambridge Notes, Past Papers, Revision Questions

International Trade and Globalisation – Foreign‑Exchange Rates

1. Objective

To understand why exchange rates move and, in particular, how changes in interest rates cause fluctuations in foreign‑exchange rates.

2. Key Definitions

Foreign‑exchange rate: the price of one currency expressed in terms of another.
Example: £0.85 / $1 means one US dollar can be exchanged for 0.85 pounds.

Floating (flexible) exchange rate: a regime in which the market determines the exchange rate; it changes in response to supply‑and‑demand forces without a fixed legal parity.

Appreciation: a rise in the value of a currency – it can buy more of a foreign currency (e.g., £1 → \$1.30 becomes £1 → \$1.40).

Depreciation: a fall in the value of a currency – it buys less of a foreign currency (e.g., £1 → \$1.30 becomes £1 → \$1.20).

3. Why Do People Buy and Sell Foreign Currencies?

Trade in goods and services – importers need foreign currency to pay overseas suppliers; exporters receive foreign currency when they sell abroad.

Investment and capital flows – investors purchase foreign assets (stocks, bonds, property) and therefore need the host‑country currency.

Speculation – traders buy a currency they expect to rise in value and sell it later for a profit.

Remittances and personal transfers – migrant workers send money home, requiring conversion.

Government intervention – central banks may buy or sell foreign currency to influence the rate.

4. Determination of the Exchange Rate in the Foreign‑Exchange Market

In a floating system the exchange rate is set where the quantity of a currency demanded equals the quantity supplied.

Demand for a currency – arises from the need to pay for imports, invest abroad, or speculate on future appreciation.

Supply of a currency – comes from exporters receiving foreign currency, foreign investors buying domestic assets, or central‑bank actions.

Expectations – if market participants expect a currency to strengthen, the demand curve shifts right; if they expect a weakening, demand shifts left.

The equilibrium is shown by the intersection of the demand and supply curves. Any shift in either curve causes the exchange rate to move.

5. Causes of Foreign‑Exchange‑Rate Fluctuations (Cambridge 6.3.5)

Changes in interest rates – higher domestic rates raise the return on domestic assets, attracting capital and causing appreciation.

Inflation differentials – higher domestic inflation reduces the real return on assets, offsetting the effect of nominal rate changes.

Political and economic risk – instability, poor credit ratings or fiscal problems can deter investors even when rates are high.

Market expectations – beliefs about future rate moves, economic performance or policy actions shift demand and supply.

Speculative activity – large‑scale buying or selling on the basis of short‑term profit motives can move the rate.

Changes in supply and demand for foreign currency – e.g., a surge in tourism earnings (supply) or a sudden rise in import bills (demand).

Liquidity of financial markets – larger, more liquid markets attract more capital flows.

5.1 The Interest‑Rate Channel (How Changes in Interest Rates Affect the Exchange Rate)

5.1.1 Basic idea

Higher domestic interest rates make domestic financial assets more attractive because they promise higher nominal returns. This draws capital into the country, increases demand for the domestic currency and leads to appreciation. The opposite occurs when rates fall.

5.1.2 Uncovered interest‑parity (UIP) framework

The expected return on a domestic asset must equal the expected return on a comparable foreign asset once the expected change in the exchange rate is taken into account:

i{d}=i{f}+E\!\left(\frac{\Delta e}{e}\right)

where

$i_{d}$ = domestic nominal interest rate,

$i_{f}$ = foreign nominal interest rate,

$E\!\left(\frac{\Delta e}{e}\right)$ = expected percentage change in the domestic currency price of foreign currency (depreciation of the domestic currency).

If $i{d}>i{f}$ and the expected depreciation is small, investors will shift funds to the domestic market, causing the domestic currency to appreciate until the parity condition is restored.

5.1.3 Step‑by‑step mechanism

Policy change – the central bank raises or lowers its policy rate.

Investor comparison – portfolio investors compare the expected return on domestic assets with that on foreign assets, incorporating expected exchange‑rate movements (UIP).

Capital movement – funds flow into the higher‑rate country (or out of the lower‑rate country).

Currency‑demand shift – increased demand for the higher‑rate currency → appreciation; reduced demand → depreciation.

5.1.4 Illustrative example

Assume the United Kingdom raises its base rate from 2 % to 4 % while the United States keeps its Federal‑Reserve rate at 2 %.

Using UIP:

4\% = 2\% + E\!\left(\frac{\Delta e}{e}\right) \;\;\Longrightarrow\;\; E\!\left(\frac{\Delta e}{e}\right)=2\%

Investors therefore expect the pound to appreciate by about 2 % against the dollar. The higher expected return on UK assets attracts foreign capital, increasing demand for pounds and causing the pound to appreciate.

5.1.5 Table – Effect of Relative Interest‑Rate Changes

Interest‑Rate Change (relative to abroad)	Relative Attractiveness of Domestic Assets	Direction of Capital Flow	Resulting Effect on Domestic Currency
Increase	More attractive (higher expected return)	Inflow of foreign capital	Appreciation
Decrease	Less attractive (lower expected return)	Outflow of domestic capital	Depreciation

6. Consequences of Exchange‑Rate Movements (Cambridge 6.3.6)

Current‑account balance – appreciation makes imports cheaper and exports more expensive, reducing export earnings and improving the import‑price term; the net effect is usually a *worsening* of the current‑account surplus or a *narrowing* of a deficit. Depreciation has the opposite effect.

Domestic price level (inflation) – a stronger currency lowers the cost of imported goods, putting downward pressure on inflation; a weaker currency raises import prices and can fuel inflation.

Balance of payments – changes in the current account feed into the overall balance of payments; persistent exchange‑rate‑induced current‑account deficits may lead to a BOP deficit.

Trade competitiveness – appreciation reduces the competitiveness of domestically produced goods abroad; depreciation enhances competitiveness.

Tourism – an appreciated currency makes a country more expensive for foreign visitors, reducing inbound tourism; depreciation attracts more tourists.

Debt servicing – borrowers with foreign‑currency debt face higher local‑currency repayments when the domestic currency depreciates and lower repayments when it appreciates.

Monetary‑policy objectives – central banks may deliberately adjust rates to steer the exchange rate toward a level that supports their inflation or growth targets.

7. Policies to Achieve Balance‑of‑Payments Stability (Cambridge 6.3.7)

Foreign‑exchange market intervention – the central bank buys its own currency to support it (reducing supply) or sells foreign currency to weaken it (increasing supply).

Sterilised intervention – the central bank offsets the domestic‑money impact of intervention by conducting offsetting open‑market operations.

Capital controls – measures such as taxes, limits on foreign‑currency borrowing or restrictions on portfolio flows to reduce volatile capital movements.

Co‑ordinated fiscal and monetary policy – using fiscal tightening or easing together with monetary policy to influence demand for the currency.

Macro‑prudential tools – e.g., higher reserve requirements for banks’ foreign‑currency lending, to limit excessive external exposure.

8. Summary – Key Points for Revision

Foreign‑exchange rate = price of one currency in terms of another.

Floating exchange rate: market‑determined; appreciation = currency gains value; depreciation = currency loses value.

Motives for buying/selling foreign currency: trade, investment, speculation, remittances, government action.

In a floating market the rate is set where demand = supply; expectations shift the curves.

Causes of fluctuations: interest‑rate changes, inflation differentials, risk perception, market expectations, speculation, supply‑demand shifts, liquidity.

Interest‑rate channel: higher domestic rates → higher expected asset returns → capital inflow → higher demand for the currency → appreciation (UIP provides the formal relationship).

Consequences affect the current account, inflation, overall balance of payments, trade competitiveness, tourism and debt servicing.

Governments can stabilise the balance of payments through FX intervention, sterilised intervention, capital controls and coordinated macro‑policy.

9. Suggested Diagram

Supply‑and‑demand graph for the domestic currency. Show the initial equilibrium (E₀) where demand (D₀) meets supply (S). When the domestic interest rate rises, the demand curve shifts right to D₁, creating a new equilibrium at a higher exchange rate (E₁), indicating appreciation. Label the axes, curves and the two equilibrium points.

10. Practice Question

Question: Country A raises its interest rate from 3 % to 5 % while Country B keeps its rate at 3 %. Using the concepts above, explain how this is likely to affect the exchange rate between Country A’s currency and Country B’s currency over the short term. Include the role of capital flows, the uncovered‑interest‑parity condition, and at least one factor that could modify the outcome (e.g., inflation differential or political risk).

Causes of foreign exchange rate fluctuations: changes in the interest rate