What sets the price of one currency in terms of another, and why does it matter?
Exchange rates: how a floating exchange rate is determined by the demand for and supply of a currency, the causes of appreciation and depreciation, and their effects on exports, imports and the economy.
An SQA Higher Economics answer on exchange rates, covering how a floating exchange rate is set by the demand for and supply of a currency, the causes of appreciation and depreciation, and their effects on exports, imports, inflation and the wider economy, using the SPICED memory aid.
Reviewed by: AI editorial process; not yet individually human-reviewed
Have a quick question? Jump to the Q&A page
Jump to a section
What this key area is asking
The SQA wants you to explain how a floating exchange rate is set by the demand for and supply of a currency, the causes of appreciation (a rise) and depreciation (a fall), and their effects on exports, imports, inflation and output. The skill is to use a demand and supply diagram for the currency and to trace a currency movement through to the wider economy.
How a floating exchange rate is determined
- Demand for a currency (say the pound) comes from foreigners who need pounds to buy UK exports, to invest in the UK, or to deposit money in UK banks to earn interest.
- Supply of the currency comes from UK residents who sell pounds to buy foreign currency for imports or to invest abroad.
Where demand and supply for the currency meet sets the exchange rate, exactly like any other market price.
Appreciation and depreciation
The effects of a currency movement
A depreciation (weaker currency):
- makes exports cheaper abroad, so foreigners buy more, and imports dearer at home, so residents buy fewer, improving the current account;
- raises aggregate demand, output and employment as demand switches to home-produced goods;
- but raises inflation, because imported goods and raw materials cost more in domestic currency.
An appreciation (stronger currency) has the opposite effects: exports dearer and imports cheaper (worsening the current account and slowing demand), but lower inflation through cheaper imports. So a currency movement always involves a trade-off, typically between the trade balance and inflation.
Worked example: tracing a depreciation
Why exchange rates matter
The exchange rate links a country's prices to the rest of the world and affects every traded good. It connects directly to the balance of payments (a key driver of the current account), to trade (competitiveness), and to monetary policy (interest rate changes move the currency). Mastering how the rate is set and how a movement ripples through trade, output and inflation is essential for the global area and for macroeconomic analysis.
Try this
Q1. Using SPICED, state what a strong pound does to imports and exports. [2 marks]
- Cue. A Strong Pound makes Imports Cheap and Exports Dear, so imports rise and exports fall.
Q2. Explain one factor that could cause a currency to depreciate. [2 marks]
- Cue. Any one of: a fall in relative interest rates (foreigners deposit less, reducing demand for the currency); weaker export demand (less demand for the currency); higher imports (more of the currency supplied); or speculation that it will fall; each lowers demand for, or raises supply of, the currency, reducing its exchange rate.
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA Higher (style)6 marksExplain the effects of a depreciation of the pound on the UK economy.Show worked answer →
Worth 6 marks. Trace the effect on trade, then on inflation and output.
Exports and imports (about 3 marks). A depreciation means the pound is worth less in terms of other currencies. UK exports become cheaper in foreign currency, so foreigners buy more of them, while imports become dearer in pounds, so UK residents buy fewer. The remember-aid is SPICED: Strong Pound, Imports Cheap, Exports Dear, so a weak pound is the reverse. This tends to raise exports and cut imports, improving the current account.
Inflation and output (about 3 marks). The higher demand for exports and the switch from imports to home-produced goods raise aggregate demand, output and employment. But dearer imports, including raw materials and fuel, push up firms' costs and the prices of imported goods, raising inflation. So a depreciation can boost growth and the trade balance but at the risk of higher inflation, the trade-off the question is testing.
SQA Higher (style)4 marksExplain two factors that could cause the pound to appreciate.Show worked answer →
Worth 4 marks. Two factors, each linked to higher demand for or lower supply of the currency.
Interest rates and exports (about 2 marks). If UK interest rates rise relative to other countries, foreign investors buy pounds to deposit in UK banks for the higher return, raising demand for the pound and causing it to appreciate. Strong demand for UK exports also raises demand for pounds (foreigners need pounds to pay for them), pushing the currency up.
Investment and speculation (about 2 marks). Increased foreign direct investment into the UK raises demand for pounds, as does speculation that the pound will rise, which prompts traders to buy it now. Each factor increases the demand for the pound (or reduces its supply), and on a demand and supply diagram for the currency this raises its exchange rate.
Related dot points
- The balance of payments: the structure of the current account, the meaning of a current account surplus and deficit, the causes of a deficit, and policies to correct one.
An SQA Higher Economics answer on the balance of payments, covering the structure of the current account (trade in goods and services, plus income), the meaning of a current account surplus and deficit, the causes of a persistent deficit, and the policies a government can use to correct one.
- Understanding global trade: the reasons countries trade and the gains from specialisation and comparative advantage, free trade versus protectionism, and the methods and effects of protection.
An SQA Higher Economics answer on global trade, covering why countries trade, the gains from specialisation and comparative advantage, the case for free trade and globalisation, the arguments for protectionism, and the methods of protection (tariffs, quotas and subsidies) with their effects.
- Multinationals and globalisation: the nature and growth of multinational companies, the reasons they locate abroad, and the costs and benefits of multinationals to host countries.
An SQA Higher Economics answer on multinationals and globalisation, covering what a multinational company is and why these firms grow, the reasons they locate in foreign countries (lower costs, new markets, resources), and the costs and benefits of multinationals to the host country.
- The impact of the global economy: developing and emerging economies and the barriers they face, the effects of globalisation on different countries, and the role of global institutions (the WTO, IMF and World Bank).
An SQA Higher Economics answer on the impact of the global economy, covering the characteristics of developing and emerging economies and the barriers to their development, the uneven effects of globalisation, and the roles of the World Trade Organisation, International Monetary Fund and World Bank.
Sources & how we know this
- Higher Economics Course Specification — SQA (Qualifications Scotland) (2024)