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Introduction to Exchange Rates

Exam code: 2281
Written by: Ashika|Reviewed by: Caroline Carroll|Updated 2 July 2026

Foreign Exchange Rates (Forex)

Foreign Exchange Rates (Forex)

  • An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18

    • International currencies are essentially products that can be bought and sold on the foreign exchange market (forex) 

  • The Central Bank of a country controls the exchange rate system that is used in determining the value of a nation's currency 

  • Two of the main exchange rate systems are

    • A floating exchange rate

    • A fixed exchange rate

1. A floating exchange rate system

  • Different currencies can be bought and sold, just like any other product

  • The forces of demand and supply determine the rate at which one currency exchanges for another

  • As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency appreciates)

  • If there is an excess supply of the currency on the forex market, then prices fall (the currency depreciates)

Two graphs showing currency appreciation and depreciation. Left: US dollar appreciates against the Euro, shifting from P1 to P2. Right: Euro depreciates against the US dollar, shifting from P1 to P2.
The relationship between the US$ and the Euro shows that as Europeans demand the $ it appreciates but by supplying their own currency it depreciates

 Diagram analysis

  • The Euro/US$ market is shown by two market diagrams - one for the USD market on the left and one for the Euro market on the right

  • The initial exchange rate equilibrium is found at P1Q1 in both markets

  • When Europeans visit the USA, they demand US$ and supply Euros

    • The increased demand for the US$ shifts the demand curve to the right which results in the value of the $ appreciating from P1 → P2 in the USD market and a new market equilibrium forms at P2Q2

    • The increased supply of the Euro shifts the supply curve to the right which results in the value of the Euro depreciating from P1 → P2  and a new market equilibrium forms at P2Q2  

2. A fixed exchange rate system

  • A system in which the country’s Central Bank intervenes in the currency market to fix (peg) the exchange rate in relation to another currency e.g US$

    • When they want their currency to appreciate, they buy it on forex markets using their foreign reserves, thus increasing its demand

    • When they want their currency to depreciate, they sell it on forex markets, thus increasing its supply

  • Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar

  • Often the peg is not at parity e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1

  • A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency

  • A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency

Evaluating Exchange Rate Systems

Evaluating Exchange Rate Systems

  • Each exchange rate system has advantages and disadvantages attached

An Evaluation of a Floating Exchange Rate Mechanism

Advantages

Disadvantages

  • Natural fluctuations in the exchange rate based on demand and supply help to maintain stable current account balances

  • If a currency appreciates, the country's exports fall and imports rise

  • If a currency depreciates, the country's exports rise and imports fall

  • Fluctuations in the exchange rate can create uncertainty for firms, leading to a reduction in investment e.g. if a firm provides a quotation to a foreign buyer based on today's exchange rate, but the exchange rate then appreciates, the domestic firm will not make as much profit as expected

  • Currency appreciation may allow costs of imported raw materials to decrease which may help lower prices in the economy

  • Currency depreciation may cause costs of imported raw materials to increase resulting in cost push inflation

  • Lower exchange rates (or a depreciating currency) may help to increase economic growth as export sales increase

  • Higher exchange rates (or an appreciating currency) may reduce/slow down economic growth as export sales decrease

  • Government does not need to monitor and maintain a floating exchange rate

 


An Evaluation of a Fixed Exchange Rate Mechanism

Advantages

Disadvantages

  • Even with an increasing demand for a country's exports, the price of its exports will remain fixed as the currency will not appreciate with more demand

  • This can boost export sales over time e.g. China did this for many years and its products remained artificially cheap to buy

  • In order to maintain the fixed exchange rate, the Central Bank has to regularly intervene in the currency market by buying or selling its own currency

  • This can be an expensive policy to maintain

  • Firms (foreign and domestic) benefit as they can agree prices with a high level of certainty as the exchange rate will not fluctuate

  • Changing the interest rate can also influence the exchange rate

  • Changing the interest rate to maintain a fixed exchange rate can have negative consequences on consumption, investment, lending, saving and borrowing

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