Exchange rates and the balance of payments

An exchange rate is the price of one currency in terms of another. Because it is a price, it is set by demand and supply, and that means the whole of this topic runs on a diagram you already know.

The words to get right

In a floating system, the market sets the rate. A rise in the value of a currency is an appreciation, and a fall is a depreciation.

In a fixed system, the government or central bank holds the rate at a set level. There the words change: a deliberate rise is a revaluation and a deliberate fall is a devaluation.

Using devaluation when you mean depreciation is a small mistake that examiners notice, so keep the pair straight.

What makes a currency rise

Demand for a currency comes from anyone who needs it. Put your country's currency on the horizontal axis and its price in foreign currency on the vertical axis, and the usual rules apply.

• Higher exports. Foreign buyers need your currency to pay for your goods, so demand for it rises and it appreciates.
• Higher interest rates at home. Foreign savers move money in to earn the better return, which raises demand for the currency. This is often called hot money.
• Foreign firms investing in your country, because they must buy your currency to do it.
• Speculators expecting the currency to rise, who buy it now.
• Confidence in the economy, which makes holding the currency feel safe.

Turn each of those round and you get the reasons a currency falls: fewer exports, more imports, lower interest rates, money leaving the country, and loss of confidence.

Who gains and who loses from a fall

This is where the marks are, because the answer is never everybody.

When a currency depreciates, exports become cheaper for foreign buyers and imports become dearer at home. So:

• Exporting firms usually gain. Their goods look cheaper abroad, so they sell more.
• Workers in exporting industries gain, because more output usually means more jobs.
• Firms that import raw materials lose. Every input now costs more in local money.
• Consumers lose, because imported goods and anything made with imported parts gets dearer. That is imported inflation.
• People planning to travel or study abroad lose, since their money buys less.
• A government that borrowed in foreign currency loses, because the debt costs more to repay in local money.

An appreciation flips all of that. Imports get cheaper, which helps consumers and holds inflation down, but exporters find it harder to compete.

Linking it to the current account

The current account records trade in goods and services, along with income and transfers. When imports are worth more than exports, there is a current account deficit.

A depreciation should improve the current account, because exports are cheaper and imports are dearer. Whether it does depends on two things.

First, elasticity. Cheaper exports only raise export earnings if foreign buyers actually respond, which needs demand for exports to be reasonably elastic. If a country sells something the world will buy at any price, and buys imports it cannot do without, a weaker currency can make the deficit worse instead of better.

Second, time. In the short run the effect is often negative. Contracts are already signed, buyers take a while to switch suppliers, and imports that are already on order still have to be paid for at the new, higher price. The improvement usually comes later. That short term worsening followed by improvement is called the J curve effect. It is on the A Level syllabus, so if you are sitting O Level you only need the point about timing, not the name.

Other ways to deal with a deficit

A weaker currency is not the only option, and saying so is good evaluation.

• Reduce demand at home through higher interest rates or higher taxes, so people import less. This works, but it slows the whole economy down.
• Protection, such as tariffs or quotas. Quick, but it invites retaliation and raises costs for domestic firms that import parts.
• Supply side policy. Improve productivity, quality and training so exports compete on something other than price. This is the slowest option and usually the most lasting one.

How to answer these questions well

Start from the diagram. Say which curve moves, why, and what happens to the rate. Then take the change in the rate through to exports, imports, and finally the current account, inflation or jobs, depending on what the question asked.

Then weigh it up. Who gains and who loses, how big the effect is likely to be, and whether the short run and the long run point the same way. A country that depends heavily on imported fuel and food will feel a depreciation very differently from one that does not, and pointing that out is exactly the kind of judgement the mark scheme rewards.