Exchange-rate questions reward students who can hold two diagrams in one chain: the currency market that sets the price of the pound, and the current account that price feeds into. Most answers manage one or the other. An A Levels economics tutor near London spends much of the macro term joining them — because the join is where the marks are. This page builds the chain once, cleanly, with numbers.
1 · The exchange rate is a price
An exchange rate is the price of one currency in terms of another — say, dollars per pound. Under a floating system, no government sets it. It comes out of a market like any other price: the demand for pounds meeting the supply of pounds.
Who demands pounds? Anyone who needs them: foreign buyers of UK exports, overseas firms investing in the UK, and — the volatile one — international savers moving hot money into UK bank accounts and bonds when UK interest rates look attractive.
Who supplies pounds? The mirror image: UK residents buying imports, UK firms investing abroad, and savers moving money out.
A rise in the pound’s price is an appreciation; a fall is a depreciation. Examiners are strict about the words: devaluation and revaluation belong to fixed exchange-rate systems, where a government changes an official rate.
2 · Reading the currency-market diagram
Draw price — dollars per pound — on the vertical axis and the quantity of pounds traded on the horizontal. Demand for pounds slopes down: the cheaper the pound, the cheaper UK goods look abroad, so more pounds are wanted. Supply slopes up. The equilibrium rate sits at the cross.
Everything interesting is a shift. The most-tested cause is the interest rate. Cut UK rates and holding pounds pays less, so hot money leaves: the demand for pounds falls and the supply of pounds rises. Both push the same way — the pound depreciates. Stronger export demand shifts demand for pounds right; an import boom shifts supply right; expectations move both, fast.
The diagram below shows the worked example’s case: a rate cut shifts demand for pounds left and the equilibrium slides down the supply curve from E₁ to E₂.
3 · From a depreciation to the current account
The current account of the balance of payments records trade in goods and services plus primary and secondary income. The exchange rate reaches it through prices.
A depreciation makes exports cheaper in foreign currency and imports dearer in pounds. The A-Level mnemonic is SPICED — Strong Pound: Imports Cheap, Exports Dear — and a depreciation runs it in reverse. Export revenue rises, import spending falls, and the current-account balance improves.
Two qualifications turn a good answer into a top one:
- The Marshall–Lerner condition. The improvement only happens if demand responds enough — formally, if the price elasticities of demand for exports and imports sum to more than 1. If both are very inelastic, a depreciation can worsen the current account: you pay more for roughly the same imports.
- The J-curve. Even when Marshall–Lerner holds, elasticities are low in the short run — contracts are signed, buyers take time to switch. So the current account often worsens first and improves later, tracing a J shape over time.
Worked example — a rate cut hits the pound
The market for pounds trades in £bn per day. Demand is P = 2.0 − 0.01Q and supply is P = 1.0 + 0.01Q, where P is the rate in dollars per pound.
Step 1 — The starting equilibrium. Set demand equal to supply: 2.0 − 0.01Q = 1.0 + 0.01Q, so 0.02Q = 1.0 and Q = 50. The rate is P = 2.0 − 0.01(50) = $1.50. Call this E₁ = (50, 1.50).
Step 2 — Check it both ways. On the supply curve, 1.0 + 0.01(50) = 1.50 — both curves pass through E₁.
Step 3 — What the rate means. At $1.50, a £300 UK export costs an American buyer 300 × 1.50 = $450, and a $600 import costs a UK buyer 600 ÷ 1.50 = £400.
Step 4 — The shock. The UK cuts interest rates. Hot money leaves, and the demand for pounds falls by $0.40 at every quantity: the new demand curve is P = 1.6 − 0.01Q.
Step 5 — The new equilibrium. 1.6 − 0.01Q = 1.0 + 0.01Q gives Q = 30 and P = $1.30. That is E₂ = (30, 1.30) — a depreciation of 0.20/1.50 = 13.3%.
Step 6 — Trace it to trade prices. The same £300 export now costs 300 × 1.30 = $390 — cheaper abroad, so export volumes rise. The $600 import now costs 600 ÷ 1.30 = £461.54 — dearer at home, so import volumes fall.
Step 7 — Does the current account improve? Suppose the price elasticity of demand for UK exports is 0.6 and for UK imports is 0.7. The sum is 1.3 > 1, so the Marshall–Lerner condition holds and the current-account balance improves.
Step 8 — Interpretation. The full chain of reasoning: rate cut → hot money outflow → demand for pounds falls → pound depreciates 13.3% → exports cheaper abroad, imports dearer at home → with elasticities summing above 1, net exports rise → current account improves — after a possible J-curve dip while volumes adjust. That chain, with the diagram, is the analysis section of an essay.
Could you run the whole chain — rate cut to hot money to a weaker pound to the current account — without dropping a link? That unbroken chain, plus the Marshall–Lerner condition, is what separates a Level 4 essay from a Level 5, and it is where most answers stall. Building it until it comes out in exam order is exactly what a one-on-one A-Level economics tutor drills with you. Book a trial session.
Practice
Q1. In the market for pounds, demand is P = 2.4 − 0.02Q and supply is P = 1.2 + 0.01Q (P in $ per £, Q in £bn). Find the equilibrium quantity and exchange rate.
Q2. The pound falls from $1.60 to $1.44. Calculate the percentage depreciation, and the dollar price of a £250 UK export before and after.
Q3. After a depreciation, the price elasticity of demand for a country’s exports is 0.45 and for its imports 0.35. State the Marshall–Lerner condition, apply it, and say what happens to the current account.
Answers. Q1: 2.4 − 0.02Q = 1.2 + 0.01Q gives 0.03Q = 1.2, so Q = 40 and P = 2.4 − 0.8 = $1.60. Q2: depreciation = (1.44 − 1.60)/1.60 = −10%; the export cost 250 × 1.60 = $400 before and 250 × 1.44 = $360 after. Q3: Marshall–Lerner requires the elasticities to sum to more than 1. Here 0.45 + 0.35 = 0.8 < 1, so the depreciation worsens the current account — the higher import bill outweighs the weak volume responses.
Key takeaways
- A floating exchange rate is a market price: demand for pounds (exports, inward investment, hot money) against supply of pounds (imports, outward investment). Interest rates move it through hot money.
- Depreciation runs SPICED in reverse: exports cheaper in foreign currency, imports dearer in pounds.
- Marshall–Lerner is the gatekeeper: the current account improves only if the export and import elasticities sum to more than 1 — and the J-curve says even then it gets worse before it gets better.
- Use the precise words: depreciation/appreciation for floating rates, devaluation/revaluation for fixed. Examiners check.
Why London students choose our A-Level economics tutoring
- Chains of reasoning, drilled: the exchange-rate-to-current-account chain is rehearsed until every link — diagram, mechanism, condition — comes out in exam order under time pressure.
- Board-matched teaching: sessions follow your specification’s wording for the balance of payments, Marshall–Lerner and the J-curve, practised on real past-paper data-response and essay questions.
- One-on-one essay marking: a tutor marks your answers against the levels descriptors and shows you exactly where analysis stops short of evaluation.
FAQ
Q: What causes a currency to depreciate?
A: Anything that reduces demand for it or raises its supply: lower relative interest rates driving hot money out, weaker export demand, a rising import bill, or expectations that the currency will fall.
Q: Does a depreciation always improve the current account?
A: No. Only if the Marshall–Lerner condition holds — the export and import elasticities must sum to more than 1. Even then, the J-curve means the balance usually worsens before improving.
Q: What is the difference between depreciation and devaluation?
A: A depreciation is a market-driven fall in a floating exchange rate; a devaluation is a deliberate cut to an official rate under a fixed system. Using the wrong term in an essay signals imprecision.
Q: What is hot money?
A: Short-term capital that moves between countries chasing the best return. It makes exchange rates highly sensitive to interest-rate decisions — which is why a rate cut typically weakens the currency.
Q: What is in the current account of the balance of payments?
A: Trade in goods, trade in services, primary income (investment income) and secondary income (transfers). Exam questions focus mostly on the trade balances, where the exchange rate bites.
Book an A Levels economics tutor near London or online
Exchange-rate essays are won by complete chains: market diagram, mechanism, condition, evaluation. One-on-one sessions build that discipline on your exam board’s own past papers, in London or online. Tell us your board and target grade, and we’ll match you with the right tutor this week.
