4.3 Exchange rates — OCR GCSE Economics revision notes

How an exchange rate is determined

An exchange rate is the price of one currency in terms of another — £1 = $1.25 means a pound buys a dollar twenty-five.

Because it is a price, it is set the same way as any other price: by supply and demand. The market being drawn is the market for pounds, with the price of a pound on the vertical axis and the quantity of pounds on the horizontal.

Demand for pounds comes from anyone who needs pounds and does not have them — foreign buyers of UK exports, tourists visiting the UK, and foreign investors buying UK assets or putting money in UK banks.

Supply of pounds comes from anyone selling pounds to obtain foreign currency — UK importers paying foreign suppliers, UK tourists going abroad, and UK investors buying assets overseas.

Where they cross is the exchange rate.

A currency is bought and sold like anything else. What raises demand for pounds — more UK exports sold, or higher UK interest rates — raises their price.

Appreciation: A rise in the exchange rate — the currency becomes stronger and buys more foreign currency.
Depreciation: A fall in the exchange rate — the currency becomes weaker and buys less foreign currency.

What causes the rate to move follows from what shifts either curve:

The pound appreciates when demand for pounds rises — UK exports selling well abroad, more tourists visiting, or UK interest rates rising so that foreign savers move money here to earn the better return. It also appreciates when the supply of pounds falls, as when UK consumers buy fewer imports.

The pound depreciates when demand for pounds falls or the supply of pounds rises — UK consumers buying more imports, UK interest rates falling, or a loss of confidence in the UK economy prompting investors to move money out.

Converting currency

The calculation is required, and it goes both ways. With a rate of £1 = $1.25:

• To convert pounds into dollars, multiply: £80 × 1.25 = $100 • To convert dollars into pounds, divide: $100 ÷ 1.25 = £80

The way to avoid getting it backwards is to sense-check the answer. Since a pound is worth more than a dollar here, a sum in dollars should be a bigger number than the same sum in pounds. If your answer in dollars came out smaller, you divided when you should have multiplied.

Worked example

The rate is £1 = €1.15. A UK firm sells a machine for £24,000 to a French buyer. The rate then falls to £1 = €1.05. Calculate the price in euros at each rate and explain the effect on the firm.

At the first rate, convert pounds into euros by multiplying.
£24,000 × 1.15 = €27,600.
At the second rate: £24,000 × 1.05 = €25,200.
The pound has depreciated, from €1.15 to €1.05.
Compare the two euro prices: the machine now costs the French buyer €2,400 less.
State what that means for the firm's sales, since the price in pounds has not changed at all.

Answer: At £1 = €1.15 the machine costs €27,600; at £1 = €1.05 it costs €25,200. The pound has depreciated, so UK exports have become cheaper for foreign buyers — €2,400 cheaper in this case — even though the UK firm has not changed its price. The firm should expect to sell more machines abroad.

Analysing exchange rate data is a named skill, and papers give a chart or table of the rate over time. Describe the trend, quote figures with their dates, identify the highest and lowest points, and use the right words: a rising line is an appreciation, a falling line a depreciation.

The effects of a change

SPICED is the standard way of remembering the direction: a Strong Pound means Imports Cheaper, Exports Dearer. The reverse — WPIDEC, weak pound, imports dearer, exports cheaper — follows from it.

It is worth understanding rather than only memorising. A strong pound buys more foreign currency, so foreign goods cost UK buyers less. And foreigners need more of their own currency to buy a pound, so anything priced in pounds costs them more.

Figure: Who gains and who loses

	Strong pound (appreciation)	Weak pound (depreciation)
UK consumers	Gain — imported goods and foreign holidays are cheaper, and lower import prices reduce inflation	Lose — imports and holidays abroad cost more, adding to inflation
UK exporters	Lose — goods cost foreign buyers more, so sales fall, and jobs may go	Gain — goods are cheaper abroad, so sales rise
UK firms buying imported materials	Gain — raw materials and components cost less, cutting production costs	Lose — imported inputs cost more, raising costs and shifting supply left
The current account	Worsens — exports fall and imports rise	Improves — exports rise and imports fall
Inflation	Falls, as cheaper imports feed through to prices	Rises, as dearer imports feed through — imported inflation

No exchange rate suits everyone: the same movement that helps consumers hurts exporters. Which effect dominates depends on how much of the economy depends on each.

Common mistake

A strong pound is not simply good for the UK. It helps consumers and firms buying imports, and hurts exporters and the jobs in exporting industries. Any answer claiming a strong currency is straightforwardly good has missed half the question.

Before you practise

An exchange rate is the price of one currency in terms of another, set by supply and demand.
Demand for pounds comes from foreign buyers of UK exports, tourists and investors.
Supply of pounds comes from UK importers, UK tourists abroad and UK investors overseas.
Appreciation is a rise in the rate; depreciation is a fall.
Higher UK interest rates attract foreign savers, raising demand for pounds and the exchange rate.
To convert pounds to another currency, multiply; to convert back, divide.
SPICED: Strong Pound, Imports Cheaper, Exports Dearer.
A strong pound helps consumers and importing firms, and hurts exporters.
A weak pound helps exporters but raises import prices and contributes to inflation.
A depreciation tends to improve the current account.

How an exchange rate is determined

Converting currency

The effects of a change

Before you practise

Now practise it