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Understanding what causes exchange rates to change is essential for analysing international competitiveness, the balance of payments, and macroeconomic policy. A movement in the exchange rate ripples through net trade, inflation, growth and the cost of servicing foreign-currency debt, so it sits at the junction of almost every macroeconomic objective. This lesson shows how a floating rate is set by the supply of and demand for a currency, which factors shift those curves and over what time horizon, and what follows when the rate moves — including the Marshall-Lerner condition and the J-curve. The forex supply/demand diagram is the indispensable analytical tool of the topic, and learning to express every shock as a shift of one curve or the other is the single most useful skill it develops.
This lesson addresses AQA A-Level Economics (7136), section 4.2.6 — The international economy: the determination of floating exchange rates, factors influencing currency demand and supply, and the effects of exchange-rate changes.
Assessment objectives in play:
The foreign-exchange (forex) market is a global, decentralised market in which currencies trade against one another. It is the world's largest financial market — the Bank for International Settlements' 2022 survey put daily turnover at around $7.5 trillion — and it operates around the clock across London, New York, Tokyo, Singapore and Hong Kong, with trading passing from one time zone to the next. Under a floating system, the exchange rate is simply a price, set where the demand for a currency equals its supply; like any competitive price it adjusts continuously to clear the market, so there is never a persistent shortage or glut of the currency.
The essential analytical move in this whole topic is therefore to treat any influence on the exchange rate as something that shifts either the demand curve or the supply curve for the currency, and then to read off the new equilibrium. Almost every exam question reduces to this: identify which curve moves and in which direction, then trace the consequences.
The vertical axis is the exchange rate (e.g., $ per £); the horizontal axis is the quantity of the currency (pounds). The demand for pounds slopes down — a cheaper pound makes UK exports and assets cheaper for foreigners, so more pounds are demanded — while the supply of pounds slopes up — a more valuable pound makes foreign goods and assets cheaper for UK residents, so more pounds are supplied to buy them. Equilibrium is at e1. A rise in demand (D to D2) — say from higher UK interest rates attracting hot money, or from stronger foreign demand for UK exports — shifts the demand curve right and appreciates the pound to e2. A rightward shift of supply would, conversely, depreciate it. Reading the diagram correctly and labelling the axes precisely (exchange rate vertically, quantity of currency horizontally) is the foundation on which the analysis marks are built.
The market is self-equilibrating under a float. If the rate were temporarily above equilibrium, the quantity of pounds supplied (UK residents buying cheap foreign goods and assets) would exceed the quantity demanded, creating an excess supply that drives the rate down; if it were below equilibrium, excess demand would drive it up. Because this adjustment happens continuously and almost instantaneously in deep, liquid markets, the observed rate is always close to the market-clearing level — which is precisely why, under a float, there is no role for a central bank to ration a shortage or absorb a surplus, and why the rate, rather than reserves, does all the adjusting.
Demand for pounds arises whenever someone needs pounds:
A rise in demand shifts D rightward and the pound appreciates. Notice that these sources span both the current account (exports, tourism, inward remittances) and the capital/financial account (inward FDI and portfolio investment) of the balance of payments — a direct link to the BoP topic, and the reason exchange-rate determination cannot be understood from trade alone.
Supply of pounds arises whenever pounds are sold to obtain other currencies — the mirror image of demand:
A rise in supply shifts S rightward and the pound depreciates. A single underlying event can move both curves: a rise in UK interest rates, for instance, increases the demand for pounds (inward hot money) and can reduce the supply (UK residents keep funds at home), so the appreciation is reinforced from both sides — a useful point to make when analysing a shock, since the strongest answers consider both blades of the scissors rather than only the demand curve.
Relative interest rates are among the most important short-run determinants, working through the capital/financial account rather than through trade.
The transmission from a relative interest-rate change to the currency runs through hot-money flows:
flowchart LR
A[UK rate rises<br/>relative to abroad] --> B[UK assets offer<br/>higher return]
B --> C[Hot money flows in:<br/>foreigners buy gilts/deposits]
C --> D[Demand for pounds<br/>rises: D shifts right]
D --> E[Pound appreciates]
E --> F[Exports dearer, imports cheaper:<br/>net trade + import inflation fall]
The word relative is crucial. What matters is the differential between domestic and foreign rates, not the absolute level — a rate rise that merely matches a rise abroad need not move the currency at all. Expectations also matter: if a rise is already anticipated, it may be "priced in", so the actual move occurs when expectations change rather than when the policy is announced.
Key Definition: Hot money is short-term, highly mobile capital that moves quickly between countries chasing the highest risk-adjusted return or anticipated currency gains.
Illustration: when the US Federal Reserve raised rates sharply and faster than other major central banks in 2022–2023, capital flowed toward the US and the dollar strengthened broadly, including against sterling — a clean example of the interest-differential channel.
Relative inflation is the dominant long-run determinant, working through competitiveness.
Key Definition: PPP holds that, in the long run, exchange rates adjust so that a common basket of goods costs the same across countries when expressed in a single currency. The higher-inflation country's currency depreciates by roughly the inflation differential.
Evaluation of PPP. PPP tracks exchange rates reasonably well over the very long run — over decades, currencies of high-inflation countries do tend to depreciate against those of low-inflation countries — but it is a poor predictor of short- and even medium-run movements, which are dominated by capital flows, interest differentials and sentiment rather than relative goods prices. PPP also fails to hold exactly for several structural reasons: transport costs, tariffs and other trade barriers drive a wedge between prices in different countries; many goods and services are non-traded (haircuts, housing, most services) and so never enter the international arbitrage that PPP relies on; product quality and consumer tastes differ; and price indices use different baskets in different countries. The Economist's "Big Mac Index" is a well-known light-hearted illustration: by comparing the local-currency price of a standardised burger across countries, it generates a PPP-implied rate that can be set against the actual market rate to suggest whether a currency is "over-" or "under-valued". The serious point behind the joke is that PPP is best treated as a long-run anchor toward which real exchange rates gravitate, not a short-run forecasting tool.
Speculators trade on expectations of future movements, and their effect is ambiguous. Stabilising speculation pushes rates toward fundamentals — buying a currency believed undervalued and selling one believed overvalued. Destabilising speculation pushes rates away from fundamentals through herd behaviour and self-fulfilling expectations, as in the 1992 ERM crisis, when the belief that sterling would be devalued itself generated the selling pressure that forced the devaluation. Because the overwhelming majority of forex turnover is financial and speculative rather than directly trade-related, short-run exchange-rate movements can detach substantially from trade fundamentals — a key reason floating rates are more volatile than the underlying economics alone would imply.
Strong economic growth and political and institutional stability attract inward investment, raising demand for the currency. Conversely, uncertainty — political instability, recession, fiscal crisis — erodes confidence and can trigger capital flight, depreciating the currency, sometimes very rapidly because sentiment can shift faster than fundamentals. Illustration: sterling fell sharply on the morning after the 2016 referendum as uncertainty about the UK's future trading arrangements rose abruptly — a confidence-channel move, not a trade-flow one.
A movement in the rate feeds back onto the current account, but not mechanically — and understanding why is one of the most heavily rewarded pieces of analysis in this topic. A depreciation improves the trade balance only if the Marshall-Lerner condition holds:
∣PEDX∣+∣PEDM∣>1
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