Exchange-rate systems and external adjustment
Exchange-rate systems and external adjustment: build the core model, apply it to evidence and qualify conclusions where outcomes depend on context.
9708 section 11.2; A Level. Checked against Cambridge's 2026–2028 Version 2 (latest version published December 2025) and 2029 Version 1 (published September 2026). Cambridge states that neither version has significant changes affecting teaching. Always follow the syllabus for the candidate's examination year.
Before you begin
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
What is the J-curve effect?
What you will learn
- Interpret nominal, real and trade-weighted exchange rates
- Explain fixed and managed exchange-rate determination
- Distinguish devaluation from depreciation and revaluation from appreciation
- Analyse exchange-rate changes under different systems
- Apply the Marshall–Lerner condition and J-curve analysis
Core model and terms
A nominal exchange rate is the money price of one currency in another; a real exchange rate adjusts for relative price levels, and a trade-weighted index combines bilateral rates using trade shares. State the quotation convention before interpreting a rise or fall. Under a fixed system, authorities maintain a parity with intervention or policy; a managed system permits some movement while the central bank influences it; a floating rate adjusts mainly through market demand and supply. Devaluation and revaluation are official changes to a fixed parity; depreciation and appreciation describe market-value changes.
Apply and evaluate
A depreciation can lower foreign-currency export prices and raise domestic import prices, but quantities adjust with lags. The Marshall-Lerner condition predicts an eventual trade-balance improvement when the sum of relevant export and import price elasticities exceeds one, subject to assumptions. The J-curve describes a possible initial deterioration as contract values change before volumes respond. Inflation differences, capacity, invoicing, imported inputs and policy credibility can alter the result.
Pause and explain
Which statement best applies exchange-rate systems and external adjustment?
Worked example
The exchange rate is quoted as foreign currency units per home currency unit and falls from 4.0 to 3.6. Identify the home-currency change and one possible short-run and later trade effect.
Show the worked solution
- One home unit now buys fewer foreign units
- The home currency has depreciated under this quotation
- Import values may rise before quantities adjust, while later export and import volumes depend on price elasticities
Answer One home unit now buys fewer foreign units → The home currency has depreciated under this quotation → Import values may rise before quantities adjust, while later export and import volumes depend on price elasticities
Try a topic test
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Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
The exchange rate is quoted as foreign currency units per home currency unit and falls from 4.0 to 3.6. Identify the home-currency change and one possible short-run and later trade effect.
Give me a hint
Check how many foreign units one home unit buys before and after the change.
Compare my reasoning
- One home unit now buys fewer foreign units
- The home currency has depreciated under this quotation
- Import values may rise before quantities adjust, while later export and import volumes depend on price elasticities
One home unit now buys fewer foreign units The home currency has depreciated under this quotation Import values may rise before quantities adjust, while later export and import volumes depend on price elasticities
Look for these in your work
- One home unit now buys fewer foreign units
- The home currency has depreciated under this quotation
- Import values may rise before quantities adjust, while later export and import volumes depend on price elasticities
Explain one difference between a nominal and a real exchange rate.
Give me a hint
Ask whether the measure adjusts for price levels as well as the currency quote.
Compare my reasoning
- A nominal rate compares currency prices
- A real rate also adjusts for relative domestic and foreign prices
- It gives a measure of relative price competitiveness
A nominal rate compares currency prices A real rate also adjusts for relative domestic and foreign prices It gives a measure of relative price competitiveness
Look for these in your work
- A nominal rate compares currency prices
- A real rate also adjusts for relative domestic and foreign prices
- It gives a measure of relative price competitiveness
Why might a trade-weighted exchange-rate index move differently from one bilateral rate?
Give me a hint
Consider the currencies’ relative importance in trade.
Compare my reasoning
- The index combines several bilateral rates
- Each is weighted by trade exposure
- A large move against a minor partner may matter less than a smaller move against a major partner
The index combines several bilateral rates Each is weighted by trade exposure A large move against a minor partner may matter less than a smaller move against a major partner
Look for these in your work
- The index combines several bilateral rates
- Each is weighted by trade exposure
- A large move against a minor partner may matter less than a smaller move against a major partner
Export and import demand elasticities are 0.7 and 0.6 in absolute value. Does the Marshall–Lerner condition hold, and what does it imply after depreciation?
Give me a hint
Add the absolute elasticities and compare the total with one.
Compare my reasoning
- 0.7 + 0.6 = 1.3, which exceeds 1
- The condition holds in this simplified case
- A depreciation may improve the trade balance after quantities adjust, though the J-curve can describe an initial deterioration
0.7 + 0.6 = 1.3, which exceeds 1 The condition holds in this simplified case A depreciation may improve the trade balance after quantities adjust, though the J-curve can describe an initial deterioration
Look for these in your work
- 0.7 + 0.6 = 1.3, which exceeds 1
- The condition holds in this simplified case
- A depreciation may improve the trade balance after quantities adjust, though the J-curve can describe an initial deterioration
Common mistakes
- Mixing up the quotation direction or treating Marshall–Lerner and the J-curve as guaranteed outcomes for every depreciation.
What can you explain now?
What is the J-curve effect?
Compare with the explanation
A depreciation may initially worsen the trade balance before quantity adjustments improve it
Contract prices and import volumes can adjust at different speeds.
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Make it stick
Before moving on, explain the central idea in exchange-rate systems and external adjustment and state one condition that could change its effect.
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