Definitions of floating exchange rate, appreciation and depreciation

Published by Patrick Mutisya · 14 days ago

IGCSE Economics 0455 – Foreign Exchange Rates

International Trade and Globalisation – Foreign Exchange Rates

Learning Objective

Define the following terms:

  • Floating exchange rate

  • Appreciation of a currency

  • Depreciation of a currency

Key Definitions

Floating Exchange Rate

A floating exchange rate is the price of one currency expressed in terms of another currency that is determined by the forces of supply and demand in the foreign‑exchange market, without direct government or central‑bank intervention.

Appreciation

An appreciation occurs when the value of a currency rises relative to another currency. In a floating system this happens when demand for the currency exceeds supply, causing the exchange rate to move in the direction of a stronger domestic currency.

For example, if the exchange rate changes from \$1.20 USD/£ to \$1.30 USD/£, the pound has appreciated because each pound now buys more US dollars.

Depreciation

A depreciation is the opposite of appreciation: the value of a currency falls relative to another currency. This occurs when supply of the currency exceeds demand, pushing the exchange rate in the direction of a weaker domestic currency.

For example, if the exchange rate moves from \$1.20 USD/£ to \$1.10 USD/£, the pound has depreciated because each pound now buys fewer US dollars.

Comparison of Floating and Fixed Exchange Rates

FeatureFloating RateFixed (Pegged) Rate
DeterminationMarket forces of supply and demandGovernment/central‑bank sets the rate
AdjustmentContinuous, can fluctuate dailyIntervention required to maintain the peg
Impact of shocksImmediate reflection in the ratePotential for reserves depletion or devaluation

Illustrative Diagram

Suggested diagram: Supply‑and‑demand graph for a foreign‑exchange market showing equilibrium exchange rate, shift causing appreciation (demand increase) and shift causing depreciation (supply increase).

Key Points to Remember

  1. In a floating system, exchange rates are not set by the government.

  2. Appreciation makes imports cheaper and exports more expensive for foreign buyers.

  3. Depreciation makes imports more expensive and exports cheaper for foreign buyers.

  4. Changes in exchange rates can affect inflation, trade balances, and economic growth.

Sample Examination Question

Explain how a depreciation of the domestic currency can affect the country's trade balance. Use appropriate economic terminology.