Explain exchange rates and currency movements
Use currency demand and supply to trace exchange-rate changes and assess effects on trade and prices.
Cambridge IGCSE Economics 0455 / IGCSE (9–1) Economics 0987, 2027–2029 Version 1. Apply each model to the stated evidence and qualify conclusions where effects depend on context. Practice is original and self-checked; it is not a Cambridge paper, mark scheme or official grade.
Before you begin
- No prior economics study is assumed. Read the scenario for the decision-maker, the market or economy involved, the time period and the evidence supplied.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
In a floating market, what can higher demand for a currency do, other things equal?
What you will learn
- Define foreign exchange rates
- Explain currency transactions
- Analyse determination and consequences of changes
Currencies are bought for several reasons
A foreign exchange rate is the price of one currency in terms of another. People and firms buy or sell foreign currency for trade, investment, speculation, government intervention, profits, interest, dividends and worker remittances.
In a floating market, demand and supply determine an equilibrium rate. Higher demand for a currency or lower supply tends to raise its value relative to another currency, using the quotation convention stated.
Appreciation and depreciation affect groups differently
Appreciation is a rise in a currency's value; depreciation is a fall. Changes can follow shifts in export or import demand, interest rates or speculation.
Depreciation may make exports cheaper to foreign buyers and imports more expensive domestically; appreciation may do the reverse. Quantities, prices and trade balances depend on responsiveness, contracts and pass-through.
Pause and explain
Why can a depreciation raise domestic import prices?
Worked example
More foreign investors want to buy a country's assets, increasing demand for its currency in a floating market. Explain the likely currency effect.
Show the worked solution
- Investors need the domestic currency to buy the assets.
- Demand for the currency shifts right.
- Its equilibrium value may appreciate, other things equal.
Answer Demand for the currency may rise and the currency may appreciate in a floating market, other things equal. The result depends on other currency flows and intervention.
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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 quotation changes from 1 domestic unit = $1.20 to $1.10. Explain whether the domestic currency appreciated or depreciated against the dollar.
Give me a hint
Compare how many dollars one domestic unit buys.
Compare my reasoning
- It now buys fewer dollars.
- The value of the domestic unit has fallen relative to the dollar.
- That is depreciation.
The domestic currency depreciated against the dollar because one unit buys $0.10 less than before.
Look for these in your work
- Quote compared
- Direction identified
- Term used correctly
A currency appreciates. Explain one possible effect on import prices and one on export competitiveness, other things equal.
Give me a hint
Compare domestic purchasing power and foreign buyers' prices.
Compare my reasoning
- Imports may become cheaper in domestic currency.
- Exports may become more expensive to foreign buyers.
- Quantities depend on pass-through and responsiveness.
Appreciation may lower import prices and make exports less price-competitive abroad. Actual effects depend on contracts, costs and how buyers respond.
Look for these in your work
- Import effect correct
- Export effect correct
- Conditions noted
A country devalues or depreciates its currency but its export volumes do not rise. Explain two reasons the expected trade response may be weak.
Give me a hint
Consider supply capacity, contract timing and demand responsiveness.
Compare my reasoning
- Foreign buyers may not respond much to price changes.
- Export firms may lack capacity or imported inputs may become more costly.
- Contracts can delay quantity adjustments.
Export volumes may respond weakly if demand is inelastic, firms lack spare capacity or imported inputs raise costs. Contracts and time lags can also delay the effect.
Look for these in your work
- Demand response considered
- Supply/cost constraint considered
- Timing considered
Common mistakes
- Ignoring which currency is the numerator in a quote
- Assuming depreciation always improves the current account
- Treating speculation as the only source of currency demand
What can you explain now?
Which transaction creates demand for a foreign currency?
Compare with the explanation
Importing goods and services
The importer may need the seller's currency.
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Make it stick
Which transaction creates demand for a foreign currency?
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