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

Foreign Exchange Rates: How They Affect Prices and Demand

What is a Foreign Exchange Rate?

A foreign exchange rate tells you how much of one currency you can get for a unit of another currency. Think of it like a price tag on a foreign currency.

Example: If 1 £ = 1.30 \$ then the exchange rate is 1 £ ↔ 1.30 \$.

Formula: \$E = \frac{P{\text{domestic}}}{P{\text{foreign}}}\$ where \$E\$ is the exchange rate.

How Exchange Rates Affect Prices

When a currency appreciates (gets stronger), foreign goods become cheaper for domestic buyers, and domestic goods become more expensive for foreigners.

When a currency depreciates (gets weaker), foreign goods become more expensive, and domestic goods become cheaper abroad.

🔄 Analogy: Imagine a vending machine that accepts only one type of coin. If the coin suddenly becomes worth more, you can buy more items with the same number of coins.

Impact on Export Demand

  • Appreciation of domestic currency → Exports become more expensive abroad → Demand falls.

  • Depreciation of domestic currency → Exports become cheaper abroad → Demand rises.

📈 Example: If the UK pound weakens, UK cars are cheaper in the US, so US buyers may import more UK cars.

Impact on Import Demand

  • Appreciation of domestic currency → Imports become cheaper → Demand rises.

  • Depreciation of domestic currency → Imports become more expensive → Demand falls.

📉 Example: If the Japanese yen strengthens, Japanese consumers can buy more imported cars from the US at a lower price.

Real‑World Example

ScenarioExchange Rate (1 £ ↔ $)UK Price (£)US Price ($)
Initial1.30£10$13
Pound Depreciates (1 £ ↔ 1.10 $)1.10£10$11
Pound Appreciates (1 £ ↔ 1.50 $)1.50£10$15

Notice how the US price changes with the exchange rate, affecting how many UK products US buyers might want.

Exam Tips

  1. Remember the key terms: appreciation and depreciation.

  2. Use the word price when describing how a change in exchange rate affects the cost of goods.

  3. When answering, clearly state whether the change is an appreciation or depreciation and then explain the impact on exports and imports.

  4. Include a simple example or diagram (like the table above) to illustrate your point.

  5. Use the formula \$E = \frac{P{\text{domestic}}}{P{\text{foreign}}}\$ if you need to calculate a new price.