Economics IGCSE Edexcel - Exchange Rates

Exchange rate: the price of one currency in terms of another.

Factors that affect the exchange rate:

1. If there is a current account surplus, then the value of the currency generally rises as the high demand for exports creates a higher demand for the currency. This cause the value of the currency to rise
2. Higher interest rates generally increase the exchange rate as it attracts foreign capital. This only happens, however, if the country's inflation level is low.
3. If speculators believe that a currency will rise, they will buy it. This increase in demand the causes the exchange rate to rise. Therefore, if the markets see news which makes an interest rate increase more likely, then the exchange rate will rise in anticipation.

Impact of a falling exchange rate:

As the exchange rate falls, exports become cheaper and imports become more expensive. Therefore, currency depreciation is a way for governments to improve the current account deficit. By using low interest rates to lower the value of the currency (loose monetary policy), governments can help with the current account balance.