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Floating Exchange Rates

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

Key exchange rate definitions

Key exchange rate definitions

  • A floating exchange rate is one that is determined by the forces of demand and supply in the foreign exchange market, without direct government or central bank control

  • Appreciation occurs when the value of a currency rises compared to another currency in a floating system (e.g. £1 = $1.25 → £1 = $1.35)

  • A depreciation occurs when the value of a currency falls compared to another currency in a floating system (e.g. £1 = $1.25 → £1 = $1.10)

Determination of the foreign exchange rate

Determination of the foreign exchange rate

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

  • The equilibrium exchange rate is where the quantity of a currency demanded equals the quantity supplied

    • At this rate, the market is in balance — there is no shortage or surplus of the currency

    • If demand increases or supply decreases, the currency appreciates

    • If demand decreases or supply increases, the currency depreciates

Demand for a currency comes from:

  • Foreigners buying the country’s exports

  • Tourists visiting the country

  • Foreign investors buying assets, shares or property

  • Speculators who expect the currency to appreciate

The supply of a currency increases when:

  • Citizens import more foreign goods and services

  • Tourists travel abroad and need foreign currency

  • Investors send money abroad

  • Speculators sell the currency expecting it to fall in value

Two graphs showing currency appreciation and depreciation; left: US dollar appreciates, right: Euro depreciates; axes show price and quantity.
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  

Causes of foreign exchange rate fluctuations

Causes of foreign exchange rate fluctuations

  • Several factors cause exchange rates to change. Three of the most common include:

Cause

Explanation

Changes in demand for exports and imports

  • If a country’s exports rise, demand for its currency increases, causing appreciation

  • If imports rise, more of the home currency is sold to buy foreign currency, leading to depreciation

Changes in interest rates

  • Higher interest rates attract foreign savers and investors, increasing demand for the currency and causing it to appreciate

  • Lower interest rates tend to reduce demand and cause depreciation

Speculation

  • If traders believe a currency will rise in value, they buy more of it, which increases demand and causes appreciation

  • If they expect it to fall, they sell the currency, increasing supply and causing depreciation

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