What determines the value of a currency, and how does it affect the economy?
Exchange rate systems, the determination of floating exchange rates, the causes and effects of appreciation and depreciation, and the Marshall-Lerner condition and the J-curve.
An answer to AQA A-Level Economics 4.2.8, covering exchange rate systems, the determination of floating exchange rates, the causes and effects of appreciation and depreciation, and the Marshall-Lerner condition and the J-curve.
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What this dot point is asking
AQA wants you to explain exchange rate systems, how a floating exchange rate is determined, the causes and effects of appreciation and depreciation, and the Marshall-Lerner condition and the J-curve. Currency questions often combine a calculation with evaluation of the trade balance.
Exchange rate systems
A managed float (dirty float) combines the two, allowing the rate to move freely most of the time but with occasional intervention to smooth volatility or resist extreme movements. A floating rate adjusts automatically to shocks (an external benefit), but introduces uncertainty for trade and investment; a fixed rate gives certainty but requires large reserves and surrenders an independent monetary policy.
Determination and the causes of changes
The demand for a currency rises with demand for the country's exports, inward investment (FDI and portfolio flows) and speculation that it will rise; the supply of the currency rises with demand for imports and outward investment. A floating rate therefore moves with interest rates (a rate rise attracts hot money inflows, raising the currency), relative inflation (higher inflation erodes competitiveness and weakens the currency), the current account position, and shifts in confidence.
Effects of appreciation and depreciation
An appreciation can therefore worsen the current account and dampen AD, but it lowers imported inflation, the so-called WIDEC effect (Weaker currency, Imports Dearer, Exports Cheaper). The net macroeconomic effect depends on the cause of the currency move and on elasticities.
Marshall-Lerner and the J-curve
Exam-style practice questions
Practice questions written in the style of AQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
AQA 20184 marksThe pound depreciates from 1.40 dollars to 1.20 dollars. Calculate the new dollar price of a UK export priced at 50 pounds, before and after, and state the effect on its competitiveness.Show worked answer →
A 4 mark calculation rewards correct conversions and a conclusion.
- Before
- dollars.
- After
- dollars.
- Effect
- The same export now costs US buyers 60 dollars rather than 70, a fall of about 14 percent, so it becomes more price-competitive and export demand is likely to rise (a weaker pound makes exports cheaper).
Markers reward both dollar prices and the conclusion that depreciation improves export competitiveness.
AQA 20219 marksAssess whether a depreciation of the currency is an effective way to reduce a current account deficit.Show worked answer →
A 9 mark assessment question needs conditions and a judgement.
- Mechanism
- Depreciation makes exports cheaper and imports dearer (expenditure switching), tending to raise net exports and improve the current account.
- Conditions
- It only works if the Marshall-Lerner condition holds (combined export and import demand elasticities exceed one). With inelastic demand the deficit can worsen. The J-curve means the balance often worsens first as volumes adjust slowly.
- Side effects
- Dearer imports raise cost-push inflation, eroding the competitiveness gain over time.
- Judgement
- Effective only if demand is elastic enough and inflation is contained; supply-side competitiveness is a more durable fix. Markers reward the elasticity condition, the J-curve and a supported stance.
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Sources & how we know this
- AQA A-level Economics (7136) specification — AQA (2015)