Exchange Rate Determination
— Economics · AS Level · Floating exchange rates —
★ Exam Tip: The teacher starred “Factors affecting demand for currency” on the board — learn the 5 demand factors and 5 supply factors by heart, and always write the 3-step chain (shift → ER change → signal → quantity change) with the paragraph answer.
1. What is an Exchange Rate?
Definition: Exchange rate = the rate at which one currency is exchanged in terms of another currency.
280 Rs : $1→ 300 Rs : $1more Rs needed per $ ⇒ Rs depreciates
300 Rs : $1→ 280 Rs : $1fewer Rs needed per $ ⇒ Rs appreciates
Remember: Demand for a currency comes from foreign residents; supply of a currency comes from domestic residents.
- Demand for currency is influenced by foreign residents (they need our currency to buy our goods/assets).
- Supply of currency is influenced by domestic residents (they sell our currency to buy foreign goods).
Floating exchange rate ⇒ DRS = SRS
↳ it is determined through the forces of demand and supply of the currency.
2. Changes in the Exchange Rate (4 cases)
Pattern: every case has the same 3 steps — #1 shift of D or S (who causes it: F.R. = foreign residents, D.R. = domestic residents) → #2 ER changes (this is the signal to the other group of residents) → #3 quantity of Rs moves along the other curve to a new equilibrium e → e₁.
① Increase in Demand for currency
Increase in Demand for currency
#1 Demand for Rs ↑ (F.R.)
Reason: low inflation rate in our country
shortage of Rs
#2 Exchange rate ↑
signal (D.R.)
#3 Qty of Rs ↑ (QRS → QRS₁)
Write-up (exam paragraph):
An increase in demand for rupees from DRS to DRS₁ due to low inflation rate in our country will create a shortage of rupees which will cause exchange rate to rise from ER to ER₁, which will provide a signal to domestic residents, so they will extend the equilibrium quantity of rupees from QRS to QRS₁. This is how the new equilibrium point is achieved from e to e₁.② Decrease in Demand for currency
Decrease in Demand for currency
#1 Demand for Rs ↓ (F.R.)
Reason: expectation about the future
surplus of Rs
#2 Exchange rate ↓
signal (D.R.)
#3 Qty of Rs ↓
Write-up (exam paragraph):
A decrease in demand for rupees from DRS to DRS₁ (e.g. expectations about the future) creates a surplus of rupees, so the exchange rate falls from ER to ER₁. This signals domestic residents, so the quantity of rupees falls from QRS to QRS₁ and e moves to e₁. (board wrote this case without the paragraph — wording follows case ①.)③ Increase in Supply of currency
Increase in Supply of currency
#1 Supply of Rs ↑ (D.R.)
Reason: high interest rate in other country
surplus of Rs
#2 Exchange rate ↓
signal (F.R.)
#3 Qty of Rs ↑ (QRS → QRS₁)
Write-up (exam paragraph):
An increase in supply of rupees from SRS to SRS₁ due to high interest rate in other country will create a surplus of rupees causing exchange rate to fall from ER to ER₁, which will provide a signal to foreign residents, so they will purchase more rupees, which will extend the equilibrium quantity of rupees from QRS to QRS₁. This is how the new equilibrium is achieved from e to e₁.④ Decrease in Supply of currency
Decrease in Supply of currency
#1 Supply of Rs ↓ (D.R.)
Reason: tariff (imports become costlier ⇒ fewer imports ⇒ fewer Rs sold)
shortage of Rs
#2 Exchange rate ↑
signal (F.R.)
#3 Qty of Rs ↓
Write-up (exam paragraph):
A decrease in supply of rupees from SRS to SRS₁ due to a tariff creates a shortage of rupees, so the exchange rate rises from ER to ER₁. This signals foreign residents, so the quantity of rupees falls from QRS to QRS₁ and e moves to e₁. (board gave no paragraph for ④ — wording follows ③.)✓ Quick Recap — 4 shifts
| Case | Cause (who) | Gap | ER | Signal to | Qty of Rs |
|---|---|---|---|---|---|
| ① D ↑ | low inflation (F.R.) | shortage | ↑ | D.R. | ↑ |
| ② D ↓ | expectations (F.R.) | surplus | ↓ | D.R. | ↓ |
| ③ S ↑ | high foreign interest (D.R.) | surplus | ↓ | F.R. | ↑ |
| ④ S ↓ | tariff (D.R.) | shortage | ↑ | F.R. | ↓ |
3. Factors affecting Demand & Supply of Currency
| Demand for currency ★ | Supply of currency |
|---|---|
| 1) Inflation in our country | 1) Interest rate ↑ in other country |
| 2) Consumer confidence / speculation of currency | 2) Inflation rate in other country |
| 3) Expectations about future / anticipation | 3) Speculation |
| 4) Interest rate | 4) Anticipation |
| 5) Balance of trade | 5) Tariff |
Inflation chain (red on board): inflation → export prices ↑ → export qty ↓ → export TR ↓ → income ↓ → payments received ↓ ⇒ demand for currency ↓
Why inflation lowers demand:
Inflation ⇒ Price ↑Export price ↑ ⇒ Export qty ↓Export TR ↓ ⇒ Income ↓Payments received ↓ ⇒ demand for Rs ↓
Note: case ① uses low inflation (demand ↑) — exactly the opposite of this chain. Low inflation here ⇒ export prices fall ⇒ more exports ⇒ more payments received ⇒ DRS shifts right.
4. Appreciation ⇄ Depreciation (self-correcting cycle)
Depreciation = fall in value of our currency (ER ↓). Appreciation = rise in value of our currency (ER ↑).
① Appreciation → leads to Depreciation
Export sideExport prices ↑Export qty ↓Export TR ↓Demand for currency ↓
Import sideImport prices ↓Import qty ↑Import TE ↑Payments ↑ ⇒ Supply of currency ↑
Demand ↓ and Supply ↑ ⇒ DEPRECIATION
Write-up:
Appreciation of our currency makes exported goods appear expensive and imported goods appear cheaper to domestic residents. A rise in the price of exports will contract export quantity, leading to a fall in export revenue; a fall in the price of imports will extend import quantity, leading to an increase in import expenditure. A fall in export revenue means less is paid to us by foreign residents, which reduces demand for our currency; more import expenditure means more is paid to foreign residents in other countries, so more of our currency is sold, which increases supply ⇒ Depreciation. This is how appreciation leads to depreciation.② Depreciation → leads to Appreciation
Export side (inflows)X price ↓X qty ↑X TR ↑Inflows ↑ ⇒ payments received ↑Demand for Rs ↑shortage of Rsvalue of Rs ↑ ⇒ ER ↑
Import side (outflows)M price ↑M qty ↓MTE ↓ ⇒ BoT surplusOutflows ↓ ⇒ BOP +vePayments made ↓ ⇒ supply of Rs ↓shortage of Rsvalue of Rs ↑ ⇒ ER ↑
Demand ↑ and Supply ↓ ⇒ APPRECIATION
Write-up:
Depreciation is a fall in the value of our currency, which reduces the price of exported goods; this extends export quantity, so export revenue increases. The price of imports rises, so import quantity contracts and import expenditure falls. Due to higher exports, more people demand our currency ⇒ appreciation; and lower import expenditure means fewer payments are made ⇒ supply of currency falls, also causing Appreciation. This is how depreciation leads to appreciation.Knock-on effects of depreciation (macro side-branch)
Depreciation ⇒ AD ↑ (X ↑, M ↓)producers raise production ⇒ output ↑ ⇒ GDP ↑derived demand for labour ↑ ⇒ economic growth ↑, unemployment ↓AD ↑ ⇒ shortage ⇒ price ↑ ⇒ demand-pull inflation
Trade balance link: depreciation ⇒ MTE ↓ ⇒ BoT surplus ⇒ outflows ↓ ⇒ BOP +ve.
5. Real-life examples (screens shown in class)
The teacher compared live rates on a phone to show stable vs fluctuating exchange rates:
| Pair | Rate | Chart shape |
|---|---|---|
| USD → AED | 3.67 | 1M / 1Y / 5Y: practically flat (tiny wiggles, range 3.67–3.673) |
| USD → SAR | 3.75 | 5Y: flat band 3.74–3.76 |
Observation: AED and SAR hardly move against the dollar ⇒ held steady (fixed/pegged by the central bank). The Pakistani rupee, in contrast, floats — below it moves every day.
| Pakistan open-market (9/3/2025) | Buying | Selling |
|---|---|---|
| US Dollar | 280.25 | 281.75 |
| UAE Dirham | 76.05 | 76.70 |
| Saudi Riyal | 74.45 | 75.00 |
| Euro | 297.85 | 300.60 |
| UK Pound | 360.50 | 364.00 |
| Australian $ | 177.00 | 179.25 |
| Canadian $ | 196.10 | 198.50 |
| China Yuan | 37.55 | 37.95 |
| Japanese Yen | 1.90 | 1.96 |
Note: Buying = what the dealer pays you for the currency; Selling = what you pay. Cross-check: 280.25 ÷ 3.67 ≈ 76.4 Rs per dirham — close to the 76.05–76.70 quoted.
✓ Full Chapter Cheat-Sheet
- ER = price of one currency in terms of another; Rs per $ ↑ ⇒ Rs depreciates, ↓ ⇒ appreciates
- Floating: DRS = SRS; demand from foreign residents, supply from domestic residents
- D ↑ (low inflation) ⇒ shortage ⇒ ER ↑ · D ↓ (expectations) ⇒ surplus ⇒ ER ↓
- S ↑ (high foreign interest) ⇒ surplus ⇒ ER ↓ · S ↓ (tariff) ⇒ shortage ⇒ ER ↑
- Every change: shift → ER change → signal to other residents → quantity moves → new e₁
- Demand factors ★: inflation, consumer confidence/speculation, expectations, interest rate, balance of trade
- Supply factors: foreign interest rate, foreign inflation, speculation, anticipation, tariff
- Appreciation ⇒ X price ↑, M price ↓ ⇒ D ↓, S ↑ ⇒ Depreciation (and vice-versa)