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How are exchange rates determined, and what does the balance of payments record?

2.4 Exchange rates and the balance of payments: floating and fixed exchange-rate systems, the causes and effects of exchange-rate changes, and the structure of the balance of payments and the current account.

An OCR H460 answer to exchange rates and the balance of payments, covering floating and fixed exchange-rate systems, the causes and effects of a depreciation or appreciation (and the Marshall-Lerner condition), and the structure of the balance of payments and the current account.

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  1. What this dot point is asking
  2. Exchange-rate systems
  3. The causes and effects of exchange-rate changes
  4. The balance of payments
  5. Examples in context
  6. Try this

What this dot point is asking

OCR wants you to distinguish floating from fixed exchange-rate systems, to explain what causes a currency to appreciate or depreciate and the effects (including the Marshall-Lerner condition and the J-curve), and to describe the structure of the balance of payments and the current account.

Exchange-rate systems

Under a float, an appreciation is a market-driven rise in the currency's value and a depreciation a fall; under a fixed system the equivalent deliberate changes are a revaluation and a devaluation. The demand for a currency rises with demand for the country's exports, inward investment and speculation; supply rises with demand for imports and outward investment.

The causes and effects of exchange-rate changes

Two refinements matter. The Marshall-Lerner condition states that a depreciation improves the current account only if the sum of the price elasticities of demand for exports and imports exceeds one. The J-curve shows that, even when this holds, the current account often worsens first (volumes are slow to adjust while prices have changed) before improving, giving a J-shaped path over time.

The balance of payments

The current account is the most examined. A deficit means a country imports more goods, services and income than it exports, financed by borrowing or selling assets (a financial-account surplus). A persistent large deficit can signal weak competitiveness, though it may be sustainable if it funds productive investment and attracts willing capital inflows.

Examples in context

  • Sterling after the 2016 referendum. The pound fell sharply, making exports cheaper but raising imported inflation, a textbook depreciation.
  • The UK current-account deficit. The UK has run persistent current-account deficits, financed by financial-account inflows, prompting debate about sustainability.
  • Pegged currencies. Some economies peg to the dollar, using reserves and interest rates to defend the rate, illustrating a fixed system.

Try this

Q1. Explain the effect of a depreciation on exports and imports. [3 marks]

  • Cue. WIDEC: exports cheaper abroad, imports dearer at home, tending to raise net exports.

Q2. State the Marshall-Lerner condition. [2 marks]

  • Cue. A depreciation improves the current account only if the price elasticities of demand for exports and imports sum to more than one.

Exam-style practice questions

Practice questions written in the style of OCR exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

OCR H460/02 20204 marksThe pound depreciates from \pounds 1 = \1.40to to \pounds 1 = \1.261.26. Calculate the percentage fall in the pound against the dollar, and find the new dollar price of a UK export priced at £500\pounds 500.
Show worked answer →

A short calculate question on exchange rates. The percentage change in the pound is 1.26−1.401.40×100=−0.141.40×100=−10%\frac{1.26 - 1.40}{1.40} \times 100 = \frac{-0.14}{1.40} \times 100 = -10\%, so the pound falls 10 per cent.

A UK export priced at £500\pounds 500 now costs overseas buyers 500 \times 1.26 = \630,downfrom, down from 500 \times 1.40 = \700700. So the export is cheaper in dollars, which should raise its competitiveness and quantity demanded.

Markers reward the 10 per cent fall, the new dollar price (\630$), and the link that a weaker pound makes exports cheaper abroad (WIDEC: weaker pound, imports dearer, exports cheaper).

OCR H460/02 202212 marksAssess the likely effects of a depreciation of a country's currency on its current account and inflation.
Show worked answer →

A levels-of-response question. Knowledge and application: explain that a depreciation makes exports cheaper abroad and imports dearer at home (WIDEC), which tends to raise net exports and improve the current account, while dearer imports raise import-cost inflation.

Analysis: develop the current-account improvement and the inflationary effect on an AD-AS framework.

Evaluation: the current account improves only if the Marshall-Lerner condition holds (the sum of export and import price elasticities exceeds one), and there is a J-curve lag, so it may worsen first. Imported inflation depends on import dependence. Conclude with a supported judgement: a depreciation tends to improve the current account and raise inflation, but the size and timing depend on elasticities and import reliance.

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