1The idea in one paragraph

An exchange rate is the price of one currency in terms of another. It is a price like any other, so it is set where the demand for a currency meets the supply of it, and it moves when either side moves. That single sentence is the whole subtopic. Everything after it is a list: who is on each side of the market, the ten things that move them, what the movement does to prices and jobs, and what happens instead when a government decides the rate rather than letting the market decide it.

2The exchange rate is a price, and the axes say whose

The country in these notes is Solvara and its currency is the Solvaran dollar, written $. Its trading partners use the euro. The exchange rate we draw is the price of one Solvaran dollar in euros, which today is €0.80 per $1.

Now the part that decides your diagram mark before you have drawn a single curve.

The exchange rate is a price. Put the price of one currency on the vertical axis, the quantity of that same currency on the horizontal axis, and every question in 4.5 turns into supply and demand.

The vertical axis is not "price". It is the price of one Solvaran dollar measured in euros, and the label must say so: € per $. The horizontal axis is not "quantity". It is the quantity of Solvaran dollars bought and sold in a period, and the label must say that too. Figure 1 is the labelling, item by item. Copy it.

Mislabelling these two axes is the single most common error in 4.5, and it is expensive: a diagram whose axes describe the wrong thing cannot earn the diagram marks even when the explanation beside it is right.

Who is on each side? Ask one question about any transaction: does somebody need to obtain dollars, or does somebody need to give dollars up?

Demand for the Solvaran dollar comes from anybody who has to pay Solvara. A German firm buying Solvaran timber has euros and needs dollars, so it buys dollars. Demand slopes down for the ordinary reason: when a dollar is cheap in euros, Solvaran goods and assets look cheap to foreigners, so more dollars are wanted.

Supply of the Solvaran dollar comes from anybody who has to pay abroad. A Solvaran family booking a holiday in France has dollars and needs euros, so it offers dollars for sale. Supply slopes up: when a dollar buys a lot of euros, foreign goods and assets look cheap to Solvarans, so more dollars are offered.

Where the two meet is the equilibrium exchange rate, e\, and the quantity traded is Q\. A floating exchange rate is one left to settle there, with no government or central bank holding it anywhere.

3Appreciation and depreciation

Two words, and they belong to a floating rate only.

• An appreciation is a rise in the value of a currency against another, brought about by the market. More euros per dollar.
• A depreciation is a fall in the value of a currency against another, brought about by the market. Fewer euros per dollar.

Each can happen in two ways, because there are two curves. Figure 3 moves demand and Figure 4 moves supply.

In the left panel of Figure 3, something makes foreigners want more dollars. Demand shifts right from D$₁ to D$₂, the market clears at the higher rate e₂, and more dollars change hands. The dollar has appreciated. In the right panel demand falls, the rate settles at the lower e₂, and the dollar has depreciated. The supply curve did not move in either panel, and drawing it moving would contradict your own explanation.

Figure 4 does the same job from the other side. More dollars offered for sale, in the left panel, pushes the rate down: a depreciation. Fewer dollars offered pushes it up: an appreciation. So an appreciation can come from a rise in demand or a fall in supply, and a depreciation from a rise in supply or a fall in demand. A question that says "the dollar appreciated" has not told you which curve moved. Read the cause and decide.

One more habit worth building now. Because an exchange rate is always the price of one currency in terms of another, every sentence has two halves. If the Solvaran dollar appreciates against the euro, the euro has depreciated against the Solvaran dollar. Say which currency you mean, every time.

4The ten things that move the curves

The guide names ten. Each one works the same way: decide whether it makes somebody need dollars or need to give dollars up, move that curve, and read off the new rate. Figure 5 has all ten with the reasoning.

Four of them need a definition before they make sense.

Foreign direct investment, or FDI, is investment that buys a lasting interest in a productive asset abroad: a factory, a mine, a controlling stake in a firm. Portfolio investment is the purchase of shares and bonds without control. The difference matters here because FDI is slow and sticky, while portfolio money can arrive and leave inside a week, which is why portfolio flows move exchange rates more violently than FDI does.

A remittance is money sent home by somebody working in another country. For a country with many of its people working abroad, remittances are a large and steady source of demand for its currency.

Speculation is buying or selling a currency to profit from an expected change in its price, rather than to pay for anything. Speculation is the one cause that can make itself come true: if enough traders expect the dollar to rise and buy it now, demand rises and the dollar does rise. That works in reverse too, and it is why a currency can fall a long way in a day on no news about the real economy.

Three of the ten carry the word relative, and it is doing real work. Solvaran inflation of 6% tells you nothing on its own. Solvaran inflation of 6% when its trading partners are at 2% tells you Solvaran goods are losing price competitiveness, so exports fall and imports rise, and the dollar depreciates. The same goes for interest rates and growth rates: compare, then conclude.

Relative growth is the one to be careful with, because it pulls both ways. Faster growth in Solvara raises Solvaran incomes, and higher incomes buy more imports, which raises the supply of dollars and pushes the rate down. But faster growth also makes Solvara a better place to invest, which raises demand for dollars and pushes the rate up. There is no automatic answer. Say which effect you think is larger, and why, and you have earned an analysis mark that a student who picked one effect and ignored the other has not.

5Two calculations you will be asked for

Converting a price between two currencies. The quote €0.80 per $1 tells you what one dollar buys. A price already in dollars is multiplied by it; a price in euros is divided by it. Figure 6 does both, with the check that catches a wrong answer.

• A jacket priced at $50 in Solvara costs 50 × 0.80 = €40 in the euro area.
• A machine priced at €600 in the euro area costs 600 ÷ 0.80 = $750 in Solvara.

Every exchange rate can be quoted both ways round, and the two quotes are reciprocals: 1 ÷ 0.80 = 1.25, so €0.80 per $1 is the same rate as $1.25 per €1. If you find dividing hard to keep straight, flip the quote first and multiply instead: €600 × 1.25 = $750, the same answer.

Calculating the change in the value of a currency. Use the ordinary percentage change formula on the rate itself:

percentage change = (new rate − old rate) ÷ old rate × 100

Suppose the dollar moves from €0.80 to €0.88. Then (0.88 − 0.80) ÷ 0.80 × 100 = +10%. The Solvaran dollar has appreciated by 10% against the euro.

Now the subtlety that catches nearly everyone. Look at the same event in the other quote. The euro was worth $1.25 and is now worth 1 ÷ 0.88 = $1.136. Its change is (1.136 − 1.25) ÷ 1.25 × 100 = −9.1%. A 10% appreciation of the dollar is a 9.1% depreciation of the euro, not a 10% one, because the two calculations divide by different starting numbers. State which currency you are measuring, and divide by that currency's old rate.

Feed the new rate back into the first calculation and you can see the consequences arriving before you have drawn anything. At €0.88, the $50 jacket now costs €44 abroad instead of €40, so Solvaran exports are dearer. The €600 machine now costs 600 ÷ 0.88 = $681.82 instead of $750, so imports into Solvara are cheaper. That is section 6 in two lines of arithmetic.

6What a change in the rate does to the economy

Take a depreciation of the Solvaran dollar. Exports are cheaper to foreigners, so export volumes rise. Imports are dearer at home, so import volumes fall. Net exports are a component of aggregate demand, so AD shifts right: output and employment rise, and so does the price level. That is the left panel of Figure 7.

The right panel is the half students forget. Solvaran firms buy fuel, components and machinery from abroad, and all of it now costs more in dollars. Their costs rise, so short-run aggregate supply shifts left: the price level rises again, and this time output falls. A depreciation therefore raises the price level through both channels and leaves the effect on output genuinely uncertain. An economy that imports most of its inputs can depreciate its way into higher prices and lower output at the same time.

An appreciation runs the whole argument backwards: net exports fall, AD shifts left, imported inputs get cheaper and SRAS shifts right, and the price level falls from both sides.

Figure 8 sets out what that means for each of the five indicators the guide names.

Four of those five are straightforward analysis. The fourth, the current account, needs a warning. A depreciation makes exports cheaper and imports dearer in price, but the balance depends on what happens to volumes, and volumes take time to respond. If buyers barely change how much they buy, a country can end up paying more for the same imports and earning less for the same exports, and the current account gets worse before it gets better. The condition that decides this is the Marshall-Lerner condition, and it is taught with the J-curve in the HL sections of 4.6 Balance of payments. Name it here, then send the reader there; do not try to prove it in a 4.5 answer.

Living standards is the row that most rewards a careful answer, because a currency movement does not treat everybody in a country alike. A depreciation cuts what a Solvaran wage buys in imported goods, which is a real fall in living standards for anyone on a fixed income. The same depreciation raises output and jobs in Solvaran exporting firms, which is a real rise for the people who work in them. "Living standards fall" is half an answer. "Living standards fall for these people and rise for those, and here is which group is larger in Solvara" is a whole one.

7Fixed exchange rates, and how they are held

A fixed exchange rate is one that a government or central bank announces and then commits to holding, usually against another currency. The announced rate is the peg.

The market does not stop wanting to move. If demand and supply would clear below the peg, there is an excess supply of dollars at the peg: more dollars are being offered than anybody wants to buy. To stop the rate falling, the central bank buys its own currency, paying with the foreign currency reserves it holds. That is the left panel of Figure 9: the bank's purchases add to demand until D$ crosses S$ exactly on the peg, and the bank's reserves of euros fall.

If the market would clear above the peg, there is an excess demand for dollars. To stop the rate rising, the bank sells its own currency and takes euros in exchange, which shifts S$ right until the market clears on the peg. Its reserves rise. Notice which way round each case runs, because writing "the central bank buys dollars" when the diagram shows supply shifting is a contradiction a marker will spot immediately.

Buying and selling currency is the direct method, and it is the one the diagram shows. A government has two other levers the guide expects you to know about. It can raise interest rates, which attracts financial capital and raises demand for its currency, holding the rate up without spending reserves; that is the link back to monetary policy in 3.5, and the cost is that interest rates are no longer free to do anything about unemployment at home. And it can borrow foreign currency from abroad to top up the reserves it is spending.

The direct method has a hard limit in one direction. A bank defending a rate from above is selling reserves, and reserves run out. A bank defending from below is buying reserves and can in principle do that for ever. That asymmetry is why currencies collapse downwards and rarely upwards.

When holding the peg becomes too expensive, the government changes it, and this is where the vocabulary matters.

• A devaluation is a deliberate reduction of the peg by the government: the currency is now officially worth less.
• A revaluation is a deliberate increase of the peg: it is now officially worth more.

Both are decisions. Appreciation and depreciation are outcomes of a market. Using a floating word for a fixed system, or a fixed word for a floating one, is the cheapest mark in this subtopic to lose. Figure 10 is the grid to memorise.

8Managed exchange rates, overvalued and undervalued

Most currencies are neither perfectly free nor firmly pegged. A managed exchange rate is one that is mostly set by the market, with the central bank intervening from time to time, often to keep the rate inside an announced band. Inside the band the rate floats; at a limit the bank steps in with exactly the operations in Figure 9. The left panel of Figure 11 shows the band.

The right panel names the two ways a rate can sit away from where the market would put it.

• A currency is overvalued when it is held above the rate the free market would set. At that rate there is an excess supply of the currency, so the central bank has to keep buying its own currency, and the reserves drain away. Imports are cheap, which holds inflation down and pleases consumers, but exports are expensive, which damages exporting firms and the jobs in them. It ends either in a devaluation or in a currency that runs out of reserves to defend.
• A currency is undervalued when it is held below the rate the free market would set. At that rate there is an excess demand for the currency, so the bank keeps selling its own currency and piles up foreign reserves. Exports are cheap, which supports export industries and employment, but imports are dear, which raises the price of imported food, fuel and machinery and cuts what a wage buys. Trading partners may treat a persistently undervalued currency as unfair competition.

Neither is a mistake by definition. A government may hold a currency below the market rate on purpose to support its exporters. Say what the country is trying to achieve, then say who inside that country pays for it.