Floating Exchange Rates

You are expected to explain/analyze (AO2) and draw (AO4) floating exchange rates and the determination of exchange rates, and calculate (AO4) the price of a good in different currencies given the exchange rate (SL+HL)

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Floating Rates

Changes

Consequences

Fixed Rates

Managed Rates

Fixed vs Floating

An exchange rate is the value of one currency in terms of another.

A floating exchange rate is a situation where the value of a currency is determined by the free market (by the supply and demand of the currency).

A currency appreciates when its value increases compared to another currency, and depreciates when its value decreases.

Drawing a floating exchange rate diagram is very straightforward; it is essentially a supply and demand diagram from microeconomics:

Note: The supply and demand of currencies in this diagram only refers to the supply and demand of that currency ready for trading. It does not account for the supply of all of the currency.

Changes in the value (price) of a currency can also be shown on this diagram. As with any supply and demand diagram, changes in price can occur from both changes in supply (S) and demand (D):

Drawing a change in supply (AO4)

If people want to convert their euros (€) into dollars ($), they first have to sell their €
- - This means the supply of € increases, which decreases € price (shown on the left)
  - This also means there is more demand for $, which increases $ price (shown on the right)

Drawing a change in demand (AO4)

If there is a sudden demand for euros (€) by people who have dollars ($), demand for € will increase
- - This means € appreciates (shown on the left)
  - This also means people with $ will first have to sell their money to turn it into €, decreasing $ price (shown on the right)

Calculations (AO4)

Given an exchange rate, you are expected to calculate the price of a good or service in another currency. Here is an example:

The rate between US dollars and euros is $1 : €1.18. Calculate the price of a $1130 smart fridge in euros.

Answer key:

1130 x 1.18 = €1333.40 <- Yeah, it's that simple

Since you need €1.18 to get $1, the euro is worth less than the dollar. Therefore, it makes sense that you need more euros than dollars to buy the same good.