Introduction to Exchange Rates | Economics for GCSE/IGCSE - Year 11 PDF Download

Foreign Exchange Rates (Forex)

• An exchange rate denotes the value of one currency relative to another, such as £1 being equivalent to €1.18.
  • Foreign currencies are essentially commodities traded on the foreign exchange market (forex).
• The control over the exchange rate system, which determines a nation's currency value, lies with the Central Bank of a country.
• Two primary exchange rate systems are:
  • Floating exchange rates
  • Fixed exchange rates

A Floating Exchange Rate System

• Various currencies are tradable commodities, subject to buying and selling like any other product.
• The interaction of demand and supply dictates the exchange rate between different currencies.
• Similar to any market, when there is a surplus demand for a currency in the forex market, its value increases (appreciates).
• Conversely, if there is an oversupply of a currency in the forex market, its value decreases (depreciates).

Diagram Analysis:

• The Euro/US$ market is depicted with two separate market diagrams: one representing the USD market on the left and another for the Euro market on the right.
• Initially, the exchange rate equilibrium is established at P₁Q₁ in both markets.
• When Europeans travel to the USA, they demand US dollars and supply Euros.
  • This surge in demand for US dollars shifts the demand curve to the right, causing the value of the dollar to appreciate from P₁ to P₂ in the USD market, and a new equilibrium emerges at P₂Q₂.
  • Simultaneously, the increased supply of Euros shifts the supply curve to the right, resulting in the depreciation of the Euro from P₁ to P₂, and a new equilibrium is established at P₂Q₂.

A Fixed Exchange Rate System

• In a fixed exchange rate system, the country's Central Bank intervenes in the currency market to establish a specific value (peg) for its currency in relation to another currency, such as the US dollar.
  • When the Central Bank aims to strengthen its currency, it purchases its own currency in the forex market using its foreign reserves, thereby increasing its demand.
  • Conversely, when the Central Bank seeks to weaken its currency, it sells its currency in the forex market, thereby increasing its supply.
• Pegs may sometimes be set at parity, such as 1 Brunei Dollar equaling 1 Singapore Dollar.
• However, pegs are often not at parity, as seen with Hong Kong pegging its currency to the US dollar at a rate of HK$ 7.75 to US$ 1.
• A revaluation occurs when the Central Bank decides to adjust the peg to increase the strength of its currency.
• Conversely, a devaluation occurs when the Central Bank decides to adjust the peg to decrease the strength of its currency.

Evaluating Exchange Rate Systems

• Every exchange rate system comes with its own set of benefits and drawbacks.

An Evaluation of A Floating Exchange Rate Mechanism

An Evaluation of A Fixed Exchange Rate Mechanism