Exchange rates
Exchange rates: build the core model, apply it to evidence and qualify conclusions where outcomes depend on context.
Section 6.4 · Exchange rates
9708 section 6.4; AS 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
Under a floating exchange rate, what most directly determines a currency’s market value?
What you will learn
- Define an exchange rate and explain a floating rate
- Distinguish appreciation from depreciation
- Trace demand and supply shifts for a currency
- Analyse AD/AS effects on output, prices and employment
- Qualify effects by elasticities, import dependence and time
Core model and terms
An exchange rate is the price of one currency in another. Under a floating system, demand and supply determine the rate. Appreciation means a currency rises in value; depreciation means it falls. State the quotation convention before interpreting a numerical exchange-rate change, because the displayed number can rise while the home currency weakens under one convention.
Apply and evaluate
A rate change alters import prices and export competitiveness. Depreciation can raise net exports and AD over time, but imported inputs may become dearer and cost-push pressure can increase; appreciation can have the reverse effects. Outcomes depend on demand and supply elasticities, contracts, import dependence and timing.
Pause and explain
Which statement best applies exchange rates?
Worked example
A currency depreciates under a floating exchange rate. Explain one possible demand-side effect and one cost-side effect.
Show the worked solution
- Home exports may become cheaper to foreign buyers
- Net exports and AD may rise if quantities respond
- Imported inputs can cost more and shift SRAS left
Answer Home exports may become cheaper to foreign buyers → Net exports and AD may rise if quantities respond → Imported inputs can cost more and shift SRAS left
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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.
A currency depreciates under a floating exchange rate. Explain one possible demand-side effect and one cost-side effect.
Give me a hint
Trace exports and imports separately from imported production costs.
Compare my reasoning
- Home exports may become cheaper to foreign buyers
- Net exports and AD may rise if quantities respond
- Imported inputs can cost more and shift SRAS left
Home exports may become cheaper to foreign buyers Net exports and AD may rise if quantities respond Imported inputs can cost more and shift SRAS left
Look for these in your work
- Home exports may become cheaper to foreign buyers
- Net exports and AD may rise if quantities respond
- Imported inputs can cost more and shift SRAS left
Foreign demand for a country’s exports rises while other currency flows are unchanged. Explain the likely currency-market change.
Give me a hint
Export sales create demand for the domestic currency.
Compare my reasoning
- Foreign buyers need domestic currency to pay exporters
- Demand for the currency shifts right
- Its floating exchange rate tends to appreciate
Foreign buyers need domestic currency to pay exporters Demand for the currency shifts right Its floating exchange rate tends to appreciate
Look for these in your work
- Foreign buyers need domestic currency to pay exporters
- Demand for the currency shifts right
- Its floating exchange rate tends to appreciate
A home-currency appreciation lowers the domestic-currency price of imported fuel. Explain a possible macroeconomic effect.
Give me a hint
Trace imported input costs into aggregate supply.
Compare my reasoning
- Fuel is an imported production input
- Lower domestic-currency cost can reduce firms’ costs
- SRAS may shift right, easing price pressure
Fuel is an imported production input Lower domestic-currency cost can reduce firms’ costs SRAS may shift right, easing price pressure
Look for these in your work
- Fuel is an imported production input
- Lower domestic-currency cost can reduce firms’ costs
- SRAS may shift right, easing price pressure
A depreciation occurs but export and import quantities barely change in the short run. Explain why the current account may not improve immediately.
Give me a hint
Consider contracts and the difference between prices and quantities.
Compare my reasoning
- Trade volumes can be slow to adjust
- Import prices may rise before import quantities fall
- The current account response can be delayed and depends on elasticities
Trade volumes can be slow to adjust Import prices may rise before import quantities fall The current account response can be delayed and depends on elasticities
Look for these in your work
- Trade volumes can be slow to adjust
- Import prices may rise before import quantities fall
- The current account response can be delayed and depends on elasticities
Common mistakes
- Interpreting a quoted exchange rate without its convention, or assuming depreciation immediately improves the current account.
What can you explain now?
Under a floating exchange rate, what most directly determines a currency’s market value?
Compare with the explanation
Demand for and supply of the currency
Market transactions shift these curves and establish the exchange rate.
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Make it stick
Before moving on, explain the central idea in exchange rates and state one condition that could change its effect.
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.