Exchange Rates
International Trade & Globalisation
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.
Common exam question
Explaining why a floating exchange rate rises or falls
Question: Explain two causes of a rise in the value of a country's floating exchange rate, or analyse what could make it fall (4–6 marks).
Asked in 2 of the 11 structured papers. Each cause is a chain: the change in demand for, or supply of, the currency, then its source. A rise comes from higher demand (more exports, more inward investment, a higher interest rate attracting hot money, speculation that the currency will rise) or lower supply (fewer imports, the country's firms investing less abroad, lower interest rates abroad). The 4-mark scheme gives the higher-demand mark and the lower-supply mark once each, so two causes need two different sources.
A fall is the same list reversed. The 6-mark scheme also credits fewer remittances sent home by the country's workers abroad, and a central bank cutting its interest rate or selling its own currency. These are section 2's reasons for buying and selling currency, seen as demand and supply.