Cambridge IGCSE and O Level Economics

Chapter 38: Foreign exchange

rates
Suggested answers to individual and group activities
Group activities
1
Currency Country
Cedi Ghana
Dirham United Arab Emirates
Dong Vietnam
Euro France
Kip Laos
Kwacha Zambia
Ouguiya Mauritania
Peso Argentina
Rand South Africa
Real Brazil
Rial Iran
Riyal Saudi Arabia 1
Rouble Russia
Rupiah Indonesia
Shilling Uganda
Won South Korea

2 a A floating exchange rate is determined by market forces.

b Certainty.
c A high exchange rate may reduce inflationary pressure, as it means that import prices are
low. This will keep down costs of production, reduce the price of finished imported goods
and services and put pressure on domestic firms to keep their price rises under control.
A disadvantage is that it may have a detrimental effect on the country’s trade position, as it
will mean that export prices are high and import prices are low.
d The fall in the value of the pound suggests that the global view was that the UK’s economic
prospects had been harmed by the referendum decision.

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Cambridge IGCSE and O Level Economics

Individual activities
1 a Japanese firms would buy Baht.
Price of D1
Baht S
in $s D

P1
P

D1
S D
0 Q Q1 Quantity of
Baht

b Tourists would sell Baht to buy the rupee.

Price of
S
Baht D
in $s S1

P
P1

S
D
S1

0 Q Q1 Quantity of
Baht

c Thai banks would sell Baht to get the currency of Ghana (cedi).
2
Price of
Baht S
D
in $s S1

P
P1

S
D
S1

0 Q Q1 Quantity of
Baht

d Fewer Bahts would be bought as fewer Thai products are being sold.
Price of D
Baht D1 S
in $s

P
P1

D
S D1
0 Q Q1 Quantity of
Baht

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Cambridge IGCSE and O Level Economics

2 a 
A fixed exchange rate, as the passage refers to the Chinese government ‘maintaining a low
price of its currency’.
b A low value of a country’s currency would mean that its export prices are low and its import
prices are high.
c Selling a currency would increase its supply. This, in turn, would reduce price. The diagram
below shows the impact of an increase in the supply of the Chinese currency, the renminbi
(yuan), on its price.
Price of
renminbi
D
in $s S
S1
P
P1

S
S1 D
0 Q Q1 Quantity
of renminbi

Suggested answers to multiple choice questions and

four-part question
Multiple choice questions
1 D
A definition question.
2 C 3
The diagram shows that the value of the Naira has fallen due to an increase in its supply.
Nigerians would sell the Naira to buy foreign currency in order to buy imports. A, B and D would
all increase demand for the Naira.
3 D
The value of a floating currency is determined by market forces. Such a currency will fall in value
if demand for it decreases and its supply increases.
4 B
The value of the pound sterling has fallen. This will cause the price of UK exports to fall and the
price of UK imports to rise. This is likely to mean that US will buy more of UK products.

Four-part question
a A devaluation is fall in a fixed exchange rate. It will be the result of a government decision to
reduce the value of the currency.
b To prevent a rise in a fixed exchange rate, a central bank could reduce the rate of interest. This
is likely to reduce demand for the currency as those placing money in the country’s financial
institutions will receive a lower return. It may also increase the supply of the currency, as some in
the country may buy foreign currency to place money in other countries’ banks.
The central bank could also sell the currency itself. It could buy foreign currencies and add them
to its reserves. Selling the currency will increase its supply, which may offset rises in demand and
so keep the value at the fixed rate.

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Cambridge IGCSE and O Level Economics

c A recession in Country X could lower or raise a Country Y's floating exchange rate. Households
and firms in Country X are likely to buy less. If Country X is major buyer of Country Y's exports,
demand for Y's currency will fall. The firms in Country X, unable to sell so much at home, may put
greater effort into exporting to Country Y. If they are successful, the supply of Country Y's currency
on foreign exchange markets will increase. A decrease in demand and an increase in the supply of
Country Y's currency will cause a depreciation of its floating exchange rate.
There is, however, a possibility that a recession in Country X, could cause Country Y’s exchange
rate to appreciate. Households and firms in Country X may think that economic prospects are
better in Country Y. As a result, they may buy Y's currency in order to put money into its financial
institutions. The higher demand for Y's currency would cause it to appreciate.
d A country may benefit from switching from a fixed to a floating exchange rate especially if its
fixed exchange rate had been under either downward or upward pressure for some time. If it had
been under downward pressure, the central bank might have been close to running out of foreign
exchange reserves. This is because it may have been using the reserves to buy the domestic
currency to maintain its value. Whether it had been under downward or upward pressure, the
central bank may have had to alter the interest rate to maintain the fixed exchange rate, even if
such an alteration would be beneficial to the government’s other objectives.
Adopting a floating exchange rate means reserves of foreign currencies no longer have to be kept
to influence the exchange rate. It also means that the exchange rate is no longer a target. The
central bank can use the rate of interest to influence total demand in the economy and so have
an impact on the country’s inflation rate and economic growth rate. A floating exchange rate may
move so as to ensure a balance between export revenue and import expenditure. If, for instance,
there is a rise in import expenditure, the supply of the currency will increase and the value of
the currency will fall. The depreciation in the exchange rate will raise the price of imports, which
would be likely to reduce import expenditure.
4
A floating exchange rate, however, can create uncertainty, which may discourage international
trade and investment. Firms may be unsure what the value of their export earnings will be and
how much they may have to pay for imports in terms of their own currency if the exchange rate
is fluctuating. Large changes in the exchange rate can be destabilising. If, for instance, there is
a large depreciation, the inflation rate may increase. This could drive the exchange rate even
lower. To avoid the destabilising effects of large fluctuations, central banks may still occasionally
intervene in the foreign exchange market even while leaving market forces to determine the
exchange rate most of the time.
A country is more likely to benefit from moving to a floating exchange rate if demand for and
supply of its currency tend to be relatively stable.

© Cambridge University Press 2018