💲 Demand for pounds
Foreign buyers need pounds to pay for UK exports of goods and services, to invest in the UK and to save in UK banks. More demand for UK exports means more demand for pounds.
Exchange Rates » Exchange Rates and How They Are Set
What you'll learn this session
Study time: 30 minutes
Edexcel spec: 2.2.3 (a), (b)
- What an exchange rate is and how to convert between currencies
- How interest rates, speculators, exports and imports change the demand for and supply of a currency
- How to draw and label a supply and demand diagram for a currency
This topic is examined on Paper 2: Macroeconomics and the Global Economy.
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Unlock This CourseWhat is an exchange rate?
An exchange rate is the price of one currency in terms of another, as you see when you swap money for a trip
Countries use different money. A shop in the UK wants pounds. A shop in the USA wants dollars. To trade across borders, someone has to swap one currency for another, and the swap rate matters.
Key terms:
- Exchange rate: the price of one currency in terms of another currency. For example, the number of dollars you get for one pound.
- Currency speculator: a person or firm that buys and sells currencies hoping to make a profit from changes in their value.
Suppose the exchange rate is £1 = $1.30. That means one pound buys 1.30 US dollars. Exchange rates change all the time, so this figure is only an example.
Converting currencies
To convert, use the rate as a multiplier or divider.
- From the "£1" currency into the other currency: multiply by the rate.
- Back again, into the "£1" currency: divide by the rate.
Worked example
The exchange rate is £1 = $1.30.
(a) A UK tourist swaps £200 into dollars: £200 × 1.30 = $260.
(b) A US trainer costs $91. What is the price in pounds? $91 ÷ 1.30 = £70.
Check (b): £70 × 1.30 = $91. Correct.
A second rate: £1 = €1.20. A UK firm buys €600 of goods. €600 ÷ 1.20 = £500.
Why do people want a currency?
A currency is bought and sold like any other product, so it has its own demand and supply. Think about the pound.
🚢 Supply of pounds
UK buyers sell pounds to get foreign money to pay for imports. More UK imports means more pounds are supplied to the currency market.
The demand and supply diagram for a currency
The diagram assumes the exchange rate is set freely by the market. Look at this example schedule for the pound against the dollar.
| Exchange rate ($ per £1) | Demand for pounds (millions a day) | Supply of pounds (millions a day) |
|---|---|---|
| 1.10 | 140 | 60 |
| 1.20 | 120 | 80 |
| 1.30 | 100 | 100 |
| 1.40 | 80 | 110 |
| 1.50 | 60 | 120 |
At $1.30 demand equals supply. This is the equilibrium exchange rate. At $1.20 demand (120) is higher than supply (80), so there is a shortage of pounds and the rate is pushed up. At $1.50 supply (120) is higher than demand (60), so there is a surplus of pounds and the rate is pushed down.
How to draw it
- Draw the vertical axis and label it "Exchange rate ($ per £1)".
- Label the horizontal axis "Quantity of pounds".
- Draw a downward-sloping curve and label it D (demand for pounds). A dearer pound makes UK exports dearer for foreign buyers, so fewer pounds are wanted.
- Draw an upward-sloping curve and label it S (supply of pounds). A dearer pound makes imports cheaper for UK buyers, so more pounds are supplied to buy them.
- Mark where the curves cross. Label the rate P1 on the vertical axis and the quantity Q1 on the horizontal axis. Draw dotted lines from the crossing point to both axes.
What moves the exchange rate?
Currency speculators buy and sell huge amounts of money, which can move exchange rates fast
When something changes the demand for or supply of a currency, a curve shifts and the equilibrium rate changes. Draw the new curve (D1 or S1), then mark the new rate P2 and quantity Q2.
| Factor | What happens | Shift on the pound diagram |
|---|---|---|
| Higher UK interest rates (compared with other countries) | Savers abroad move money into UK banks to earn more interest. They must buy pounds first. | D shifts right to D1. The rate rises. |
| Lower UK interest rates | Money leaves UK banks for countries with better returns. Pounds are sold. | D shifts left (and S shifts right). The rate falls. |
| Speculators expect the pound to rise | They buy pounds now to sell later at a profit. | D shifts right. The rate rises. |
| Speculators expect the pound to fall | They sell pounds now before the value drops. | S shifts right. The rate falls. |
| UK exports rise | Foreign buyers need more pounds to pay for them. | D shifts right. The rate rises. |
| UK imports rise | UK buyers sell more pounds to get foreign currency. | S shifts right. The rate falls. |
Speculation can be powerful. If many speculators expect a fall and all sell at once, their selling can cause the very fall they expected. What a rise or fall means for firms and for the current account is covered in the lesson Appreciation and Depreciation.
Worked example
On the schedule above, foreign firms start buying many more UK goods. Demand for pounds rises by 30 million at every rate.
New demand: $1.30 gives 130, $1.40 gives 110, $1.50 gives 90. Supply at $1.40 is 110. The curves now cross at $1.40 (quantity 110 million). The exchange rate has risen from $1.30 to $1.40.
Common mistakes
- Mixing up which way to convert. Check the answer: if £1 buys more than one dollar, then a number of pounds should give a bigger number of dollars.
- Labelling the vertical axis "Price" only. Say what the rate is, such as "$ per £1".
- Putting exports on the supply side. Exports raise the demand for the home currency. Imports raise the supply.
- Forgetting that interest rate effects depend on rates compared with other countries.
Exam-style question
Country Zarmia uses the kell (K). The exchange rate is K1 = $0.50. Zarmia's central bank raises its interest rate from 3% to 6%. Other countries keep their interest rates the same. Zarmia also sells more cocoa to the USA.
(a) Define 'exchange rate'. [2 marks]
(b) A US visitor to Zarmia swaps $200 into kells. Calculate how many kells the visitor receives. [2 marks]
(c) Explain one reason why the higher interest rate may increase the demand for the kell. [3 marks]
(d) Explain, using a demand and supply diagram, how more cocoa exports to the USA could change the exchange rate of the kell. [4 marks]
Model answer
(a) The price of one currency (1) in terms of another currency (1).
(b) $200 ÷ 0.50 (1) = K400 (1). (K1 = $0.50 means each dollar buys K2, so $200 buys K400.)
(c) The higher interest rate means savers in other countries can earn more by saving in Zarmian banks (1). To do this they must buy kells (1). This increases the demand for the kell (1).
(d) The vertical axis is the exchange rate ($ per K1) and the horizontal axis is the quantity of kells (1). More cocoa exports mean US buyers need more kells, so the demand curve shifts right from D to D1 (1). The curves cross at a higher point, so the equilibrium rate rises from P1 to P2 (1) and the quantity traded rises from Q1 to Q2 (1).
Exam tip
In a currency diagram question, name what is on each axis and say which curve shifts and why. Marks are often lost for a missing axis label.
Recap
- An exchange rate is the price of one currency in terms of another.
- To convert, multiply by the rate going one way and divide by it going the other. Check the answer makes sense.
- Demand for a currency comes from exports and from investors and savers; supply comes from imports.
- Higher interest rates, speculators expecting a rise and rising exports increase demand for a currency, so the rate rises. Lower interest rates, speculators expecting a fall and rising imports reduce demand for it or increase its supply, so the rate falls.
- On the diagram, label the axes, D and S, then show the shift and the new rate and quantity (P2, Q2).