Causes of Exchange-Rate Fluctuations — Exchange Rates | IGCSE Economics

Exam Frequency Analysis

Past paper frequency (2018 to 2024)

This topic accounts for approximately 11% of your exam marks.

increasing

Medium

Increasing11%

Exchange rate definitions, depreciation/appreciation effects on exports, imports, and inflation are increasingly examined since 2021.

Anything that raises demand for the currency, or reduces its supply, causes an . Anything that reduces demand or raises supply causes a . The syllabus focuses on three causes.

1. Changes in demand for exports and imports

Rising exports. Foreign buyers need the domestic currency to pay for the goods, so demand for the currency rises and it appreciates.
Rising imports. Domestic residents sell their currency to obtain foreign currency, so the supply of the currency rises and it depreciates.

A country with strong exports tends to have a strong currency; a country buying far more imports than it sells exports tends to have a weakening one.

2. Changes in the interest rate

A higher domestic interest rate attracts foreign investors looking for better returns. They buy the currency to hold deposits or bonds, so demand rises and the currency appreciates.
A lower domestic interest rate pushes investors toward higher-yielding currencies abroad, so supply rises and the currency depreciates.

These short-term capital flows (sometimes called "hot money") can move very quickly, which is why central-bank interest-rate decisions have such an immediate effect on the exchange rate.

3. Speculation

If many traders believe a currency will rise, they buy it now, and that buying itself pushes the rate up.
If they believe it will fall, they sell it now, driving the rate down. Speculation can therefore be self-fulfilling in the short run.

Exam tip

Explain two causes of a rise in a floating exchange rate (4 marks)

What comes up: "Explain two causes of an increase in the value of a country's floating exchange rate." Each cause earns 1 mark and the explanation of the mechanism earns the second mark; only the first two (or three) causes given are credited, so lead with your strongest.

Write (two marks per cause, pick two): (1) A rise in exports (1) increases foreign demand for the currency, pushing its value up (1). (2) A higher domestic interest rate (1) attracts foreign investors seeking better returns, raising demand for the currency (1). (3) Speculation that the currency will rise (1) leads traders to buy it now, increasing demand (1).

Watch out: simply writing "more demand for the currency" without stating what caused that demand earns only 1 mark. Name the specific source and link it to currency demand.