Cambridge International as and a level Economics Ebook

 
purchase goods and services from the country
■
 
invest in the country
■
 
speculate on making a profit if the value of the currency 
should rise in the future. Financial institutions also 
speculate on future currency movements on their own 
behalf. The currency will be sold to buy imports, to invest 
abroad and in expectation that the value of the currency 
will fall in the future.
Figure 4.12
shows that an increase in the supply of a 
currency will result in a fall in its value.
A fall in the value of a currency caused by market 
forces is known as a depreciation. A rise in the value 
Figure 4.12 
The eff ect of an increase in the supply of currency
Price of $s in £s
P
0
Quantity of $s
D
D
S
1
S
1
S
S
Q
1
Q
P
1
Floating exchange rate: 
an exchange rate that is 
determined by the market forces of demand and supply.
KEY TERM
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Cambridge International AS Level Economics
of the currency, caused by an increase in demand and/
or a decrease in supply is known as an appreciation. 
Figure 4.13
 shows an appreciation in the value of the 
pound sterling. Th
is might have been caused by a fall in 
US demand for UK imports. If Americans are buying 
fewer UK imports, they will need to sell fewer dollars to 
purchase pounds sterling.
Th
ere are a number of advantages that may be 
gained from operating a fl oating exchange rate. One 
is that the exchange rate should, in theory, move to 
restore a balance on the current account of the balance 
of payments. For instance, if a country has a current 
account defi cit, demand for the currency will fall while 
its supply increases. Th
is will lead to a depreciation, 
making exports cheaper and imports more expensive. 
Given elastic demand for exports and imports, this will 
result in a rise in export revenue and a fall in import 
expenditure.
With the government not infl uencing the value of the 
exchange rate, reserves of foreign currency do not have to 
be held and can be used for other purposes. Th
e exchange 
rate is not a government target and so the government can 
concentrate on other aims.
Th
ere are also potential disadvantages of a fl oating 
exchange rate. Th
e exchange rate may fl uctuate 
signifi cantly. Changes in the exchange rate may make it 
diffi
cult to estimate how much will be earned by selling 
exports and how much will have to be paid for imports. 
Th
is uncertainty may discourage trade and investment, 
although forward markets provide the opportunity to 
agree on a price now at which to sell or buy a currency in 
the future.
Another potential disadvantage is that a fl oating 
rate may remove pressure on the government to 
maintain price stability. A government may rely on a 
fall in a fl oating exchange rate to restore any loss in 
international competitiveness arising from infl ation. 
Th
ere is a risk, however, that a fall in the exchange rate 
will increase infl ationary pressure. Th
is is because the 
price of imported products will increase. As a result, 
the cost of imported raw materials will rise, the price 
of imported fi nished products will increase and the 
pressure on domestic fi rms to restrict their price rises 
will be reduced.
Th
ere is also no guarantee that a fl oating exchange 
rate will eliminate a current account surplus or defi cit. 
For instance, the value of an exchange rate may be 
pushed up despite the country having a current account 
defi cit if speculators are buying the currency expecting it 
to rise in value.