How are exchange rates set, and how do they affect the balance of payments?
Exchange rate systems, the determinants of floating exchange rates, the effects of changes in the exchange rate, the balance of payments, and the relationship between competitiveness and the current account.
An Edexcel A-Level Economics A answer to exchange rates and the balance of payments, covering floating, fixed and managed exchange rate systems, the determinants of a floating rate, the effects of appreciation and depreciation, the Marshall-Lerner condition and J-curve, the structure of the balance of payments, and international competitiveness.
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What this dot point is asking
Edexcel wants you to compare exchange rate systems, explain what determines a floating rate, analyse the effects of a changing exchange rate, explain the structure of the balance of payments, and link competitiveness to the current account.
Exchange rate systems
A floating rate appreciates (rises) when demand for the currency rises, for example from stronger exports, higher interest rates attracting hot-money capital inflows, or speculation; it depreciates when these fall. The demand and supply of a currency can be drawn like any market, with the exchange rate on the vertical axis.
Effects of a changing exchange rate
The balance of payments and competitiveness
International competitiveness depends on relative unit labour costs, productivity, the quality and design of goods, and the exchange rate. Persistent uncompetitiveness shows up as a structural current-account deficit, which can be addressed by supply-side policy (raising productivity) as well as a weaker currency.
Examples in context
- Sterling after the 2016 referendum. The pound fell around , boosting export competitiveness over time but raising imported inflation, a real Marshall-Lerner and J-curve case.
- Chinese yuan management. China has long managed its currency, holding it lower to support exports, a textbook managed float.
- UK current account deficit. A persistent deficit (often to of GDP) financed by financial-account inflows shows the accounts balancing overall.
- Hot money and interest rates. When the Bank of England raises rates, capital inflows can appreciate the pound, illustrating the interest-rate determinant.
Try this
Q1. Explain how a depreciation of the pound affects export prices and import prices. [3 marks]
- Cue. Exports become cheaper in foreign currency and imports become dearer in domestic currency (WPIDEC).
Q2. Explain the Marshall-Lerner condition. [4 marks]
- Cue. A depreciation improves the current account only if the combined price elasticities of demand for exports and imports are greater than one.
Exam-style practice questions
Practice questions written in the style of Pearson Edexcel exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
Edexcel 20194 marksThe pound depreciates from \1.40\. Calculate the percentage depreciation, and state the new dollar price of a UK export priced at .Show worked answer →
A short calculate question on exchange-rate change.
Percentage depreciation .
A export now costs overseas buyers 100 \times 1.26 = \126\, making UK exports cheaper and more competitive.
Markers reward (1) the percentage-change method giving , (2) the new dollar price of \126$, (3) noting exports become cheaper abroad.
Edexcel 202312 marksAssess the likely effects of a sustained depreciation of a country's currency on its current account and inflation.Show worked answer →
A 12 mark question (around 8 KAA, 4 evaluation).
KAA: a depreciation makes exports cheaper and imports dearer (WPIDEC), so the current account improves if the Marshall-Lerner condition holds, while dearer imports raise cost-push inflation. Trace the chains on demand and supply for the currency.
Evaluation: the J-curve means the current account worsens first; the size depends on elasticities, spare capacity and the cause of the depreciation. Reach a judgement weighing the competitiveness gain against imported inflation.
Markers reward the Marshall-Lerner and J-curve points and balance.
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Sources & how we know this
- Pearson Edexcel A-Level Economics A (9EC0) specification — Pearson Edexcel (2015)