IGCSE Economics 0455 – International Trade and Globalisation: Foreign Exchange Rates
International Trade and Globalisation – Foreign Exchange Rates
Learning Objective
Understand how changes in foreign exchange rates affect the prices of exports and imports and the resulting demand for these goods.
Key Concepts
Foreign exchange rate (FX rate): The price of one currency expressed in terms of another currency.
Appreciation: A rise in the value of the home currency relative to a foreign currency.
Depreciation: A fall in the value of the home currency relative to a foreign currency.
Export price in foreign currency: The price that foreign buyers pay, usually expressed in their own currency.
Import price in home currency: The price that domestic buyers pay for foreign goods, expressed in the home currency.
How Exchange‑Rate Movements Change Prices
Assume the home country uses the pound (£) and the foreign country uses the US dollar (\$). The exchange rate is expressed as £/\$ (pounds per dollar).
Scenario
Exchange Rate (£/$)
Effect on Export Price (in $)
Effect on Import Price (in £)
Appreciation of £
↑ (e.g., from 0.80 to 0.90)
Export price in \$ ↑ (foreign buyers pay more \$ for the same £ price)
Import price in £ ↓ (domestic buyers pay fewer £ for the same $ price)
Depreciation of £
↓ (e.g., from 0.80 to 0.70)
Export price in \$ ↓ (foreign buyers pay fewer \$ for the same £ price)
Import price in £ ↑ (domestic buyers pay more £ for the same $ price)
Impact on Demand for Exports
When the home currency depreciates, export goods become cheaper for foreign buyers, leading to an increase in the quantity demanded of exports. Conversely, an appreciation makes exports more expensive abroad, reducing demand.
Diagram suggestion:
Suggested diagram: Export‑demand curve showing a right‑ward shift when the home currency depreciates and a left‑ward shift when it appreciates.
Impact on Demand for Imports
When the home currency depreciates, import goods become more expensive for domestic consumers, reducing the quantity demanded of imports. An appreciation makes imports cheaper, increasing their demand.
Diagram suggestion:
Suggested diagram: Import‑demand curve shifting left after depreciation and right after appreciation.
Combined Effect on Trade Balance
The overall effect on the trade balance depends on the price elasticity of export and import demand:
If export demand is elastic, a depreciation can significantly increase export revenue, improving the trade balance.
If import demand is inelastic, the rise in import prices may not reduce import volume much, potentially worsening the trade balance despite depreciation.
Mathematical Illustration
Let:
\$P_{e}\$ = price of export in foreign currency
\$E\$ = exchange rate (£ per $)
\$P_{h}\$ = price of import in home currency
\$P^{*}\$ = price of import in foreign currency
Export price in foreign currency:
\$P{e} = \frac{P{h}}{E}\$
Import price in home currency:
\$P_{h} = P^{*} \times E\$
From the equations, a decrease in \$E\$ (depreciation) reduces \$P{e}\$ and raises \$P{h}\$, confirming the qualitative analysis above.
Summary Table
Change in Exchange Rate
Export Price (foreign currency)
Export Demand
Import Price (home currency)
Import Demand
Depreciation of home currency
↓
↑
↑
↓
Appreciation of home currency
↑
↓
↓
↑
Key Points for Exam Answers
Define appreciation and depreciation clearly.
Explain the direction of price changes for exports and imports using the exchange‑rate formula.
Link price changes to movements along or shifts of the export and import demand curves.
Discuss the role of price elasticity in determining the overall impact on the trade balance.