What is a foreign exchange market?

A foreign exchange market is the global network in which currencies are bought and sold against one another. It has no single physical location: banks, brokers, corporations, fund managers and central banks deal with each other electronically around the clock, with trading passing from one financial centre to another as the day moves round the world. The price established in it is the exchange rate, the amount of one currency that must be given to obtain a unit of another.

What determines the price of one currency against another in a floating market?

The rate is set where demand for the currency equals its supply. Demand comes from foreigners buying the country's exports, from investors wanting its assets, and from speculators expecting it to appreciate; supply comes from residents buying imports, investing abroad, or selling the currency. Anything that shifts either side — relative interest rates, relative inflation, trade flows or expectations — moves the rate.

Who are the main participants in the foreign exchange market and why does each take part?

Commercial banks and dealers make up the largest share of turnover, quoting prices to each other and to clients and managing their own positions. Firms take part because exporters receive foreign currency they need to convert and importers must buy foreign currency to pay suppliers. Investors and fund managers buy currency in order to purchase foreign shares, bonds and property. Tourists and migrants convert currency for travel and remittances. Speculators trade purely to profit from expected changes in the rate, and central banks intervene to influence the rate or manage reserves.

Explain how the exchange rate is determined in a freely floating market.

The rate is set where the demand for the currency equals its supply. On a diagram with the exchange rate, say dollars per pound, on the vertical axis and the quantity of pounds traded on the horizontal axis, the demand curve for pounds slopes downward because a cheaper pound makes British goods and assets cheaper for foreigners, so more pounds are wanted. The supply curve of pounds slopes upward because a dearer pound buys more foreign currency, making foreign goods and assets cheaper for British residents, so more pounds are offered. Equilibrium is at the intersection, and any excess demand or supply moves the rate until the two are equal again.

Why does the demand curve for a currency slope downwards?

A fall in the external value of the pound means that foreign buyers need fewer units of their own currency to obtain a pound, so British goods, services and assets become cheaper to them. They therefore buy more of these, and to do so they must buy more pounds. A lower price of the pound is thus associated with a larger quantity of pounds demanded, giving a downward-sloping curve. The reasoning is exactly the demand relationship applied to a currency, which is being treated as the good whose price is the exchange rate.

CCEA A-Level Economics 4410

Key Economic Concepts

Topic overview The four factors of production Positive statements and normative judgements Economic agents and what they are trying to achieve Capital goods and consumption goods Product markets and factor markets

The Basic Economic Problem of Scarcity and Choice

Topic overview Scarcity, choice and opportunity cost Drawing and reading the production possibility frontier Using a PPF to show choice, opportunity cost, efficiency and growth Why an economy operates inside its frontier Specialisation and the division of labour Free market, planned and mixed economies

Demand and Supply in Product Markets

Topic overview What determines demand and what determines supply Movements along a curve versus shifts of a curve Why the demand curve slopes downwards Why the supply curve slopes upwards: marginal cost and the profit incentive Consumer surplus and producer surplus When consumers do not behave rationally

Markets and Equilibrium

Topic overview Market equilibrium and how markets clear How shifts in demand and supply change the equilibrium Price signals, incentives, rationing and the role of profit Joint, composite and derived demand and joint supply Tracing effects between interrelated markets Community surplus and allocative efficiency Demand and supply in housing, energy and commodity markets Indirect taxes and subsidies: impact and incidence

Elasticity of Demand and Supply

Topic overview Price elasticity of demand: measuring and interpreting Income and cross elasticity: normal, inferior, substitutes and complements Price elasticity of supply What determines the value of an elasticity Elasticity and total revenue How useful is elasticity for firms and government?

Factor Markets: Labour

Topic overview How a competitive labour market sets the wage Elasticity of labour demand and labour supply Wage differentials and why they persist Economic rent and transfer earnings Flexibility: trade unions, welfare and migration Minimum wages and government intervention in the labour market

Market Failures and Imperfections

Topic overview Market equilibrium, the social optimum and the meaning of market failure Externalities: private, external and social costs and benefits Community surplus and the externality diagrams Calculating and interpreting welfare loss Public goods, quasi-public goods and the free rider problem The consequences of missing markets for public goods Merit goods and demerit goods Information gaps and asymmetric information The consequences of merit goods, demerit goods and information failure Market power and other market imperfections Income and wealth inequality Absolute and relative poverty

Government Intervention in Markets

Topic overview Why governments step into markets Indirect taxes Subsidies, and choosing between taxes and subsidies Maximum and minimum prices State provision Regulation Information provision Tradeable pollution permits Government failure

The Circular Flow of Income

Topic overview Households, firms and the two-way flow Injections and withdrawals in an open economy with government Equilibrium and change in the circular flow

Measuring National Income

Topic overview Three routes to the same total: income, expenditure and output GDP as a measure of welfare and its limitations Domestic or national? GDP and GNP compared Nominal and real values: correcting for price changes Total and per capita measures

Aggregate Demand

Topic overview The four components of aggregate demand Why the aggregate demand curve slopes downwards Movements along and shifts in aggregate demand Factors that shift aggregate demand Investment: gross, net and fixed capital

Aggregate Supply

Topic overview Why short-run aggregate supply slopes upwards Factors that shift short-run aggregate supply Movements along and shifts in aggregate supply From the short run to the long run What determines long-run aggregate supply Keynesian and neoclassical views of long-run aggregate supply

Macroeconomic Equilibrium

Topic overview How aggregate demand and aggregate supply determine equilibrium Applying AD-AS analysis to growth and unemployment Applying AD-AS analysis to inflation

Macroeconomic Objectives

Topic overview Why governments target inflation, unemployment, the external balance and growth Objectives beyond the main four: the environment and the distribution of income and wealth Picturing inequality: the Lorenz curve and the Gini coefficient Where the objectives collide: the main policy conflicts Judging the trade-offs: how sharp is a conflict?

Inflation

Topic overview Inflation, deflation and disinflation: what the words actually mean Measuring the rate: the CPI and the RPI Working with index numbers Building a price index: the basket and the significance of weights Demand-pull and cost-push inflation The costs and consequences of inflation and deflation The policy response to inflation

Unemployment

Topic overview The claimant count and the ILO measure of unemployment Calculating and interpreting unemployment statistics Unemployment and economic inactivity: a distinction that changes the numbers The types of unemployment and what distinguishes them The causes of unemployment and of economic inactivity The costs and consequences of unemployment and inactivity Policies for unemployment and intervention in the labour market

Economic Growth

Topic overview Actual and potential growth on a production possibility frontier Measuring economic growth The economic cycle and output gaps The causes of economic growth Benefits, costs and the sustainability of growth Policies to promote economic growth using AD–AS analysis

Fiscal Policy and Its Effects

Topic overview What fiscal policy is and how it works Government spending and taxation: the main categories Direct and indirect taxation Fiscal policy in the AD-AS model Evaluating the impact of fiscal policy on output, employment, prices and agents

Monetary Policy

Topic overview The nature of monetary policy and the interest rate instrument The transmission mechanism from interest rates to aggregate demand Monetary policy in the AD-AS model Evaluating the impact of monetary policy on output, employment, prices and agents

Supply-Side Policies

Topic overview The nature of supply-side policy and tax cuts Deregulation and evaluating market-based supply-side policy Competition and innovation as supply-side policy Infrastructure as supply-side policy Labour market reform Education, training and the skills of the workforce Labour productivity: determinants and significance Supply-side policies in the AD-AS model Evaluating the impact of supply-side policies

Exchange Rates and the National Economy

Topic overview What an exchange rate is and how it is measured Exchange rate changes in the AD-AS model Holding the exchange rate above or below the market clearing level Why a government might have an exchange rate policy Evaluating the impact of exchange rate changes on output, employment, prices and agents

Short Run Versus Long Run

Topic overview The short run, the long run and the law of diminishing returns Fixed, variable and total costs of production Calculating and drawing the short-run cost curves Revenue curves: total, average and marginal revenue The profit-maximising output Shutdown, breakeven, and normal and supernormal profit Long-run cost, economies of scale and minimum efficient scale Efficiency, X inefficiency and the effects of firm size

Business Objectives

Topic overview Why firms pursue maximum profit Alternative objectives: revenue, growth, managerial utility, satisficing and the environment Ownership, control and the principal-agent problem Stakeholders, and public versus private sector objectives

Business Growth

Topic overview How and why firms grow, and why some stay small Organic growth versus merger and acquisition Horizontal, vertical and conglomerate integration Evaluating the motives for and consequences of growth

Measuring Markets

Topic overview Market size, market share and market growth The n firm concentration ratio Difficulties in measuring market share accurately Sales value against sales volume

Analysing Market Structures

Topic overview What defines a market structure Price and output across the structures Efficiency across the market structures Market structure and innovation How useful are the models of market structure?

Perfect Competition

Topic overview The price taker's revenue curves and short-run equilibrium The firm and the industry side by side How the market moves from the short run to the long run

Monopoly

Topic overview Barriers to entry Monopoly equilibrium and its consequences Price discrimination Natural monopoly Creative destruction

Monopolistic Competition

Topic overview The firm's demand curve when products are differentiated Short-run equilibrium for the firm Long-run equilibrium and excess capacity How the market moves from the short run to the long run

Oligopoly

Topic overview Concentration and interdependence: what marks out an oligopoly Collusion and price leadership Price wars and sustaining collusion Non-price competition and product differentiation The kinked demand curve model Game theory and the pay-off matrix Evaluating the costs and benefits of oligopoly

Contestable Markets

Topic overview What makes a market contestable Sunk costs and hit-and-run entry How ease of entry changes the behaviour of firms Judging contestability and its significance

Competition Policy

Topic overview The aims and shape of competition policy Breaking up firms and controlling mergers Regulation, regulators and price caps Evaluating regulation and its alternatives Taxation and subsidies as competition remedies Nationalisation Privatisation, and choosing between public and private ownership Banning unfair trading practices Judging competition policy and government failure

Trade and Globalisation

Topic overview Calculating absolute and comparative advantage Evaluating comparative advantage and its limits The gains and losses from free trade Globalisation and its effects Foreign direct investment The instruments of protectionism Evaluating protectionism The World Trade Organisation Trading blocs, trade creation and trade diversion

Economic Development

Topic overview What economic development means and how it differs from growth The difficulties of measuring development National income statistics and comparisons of living standards The Human Development Index Growth in less developed countries: benefits, costs and constraints Promoting development: aid, institutions, debt and trade

Balance of Payments

Topic overview How the balance of payments is put together Consequences of current account deficits and surpluses Policies to correct current account imbalances Expenditure-switching and expenditure-reducing policies

Exchange Rate Systems and Competitiveness

Topic overview How foreign exchange markets operate The influences on currency demand and supply Monetary policy, intervention and other influences on the exchange rate Fixed and floating exchange rate systems The Marshall-Lerner condition and the J-curve The effect of exchange rate changes on the current account Trade-weighted exchange rate indices Purchasing power parity and comparing competitiveness Evaluating exchange rate policy

European Union (EU)

Topic overview The economic case for membership of a trading bloc The costs and constraints of membership, and the position of candidate countries Enlargement, withdrawal and changes in the structure of the union The Eurozone: one currency and one interest rate

Monetary Policy and the Financial Sector

Topic overview Central banks, the banking sector and the money supply Setting the base rate and the transmission of monetary policy The Fisher equation of exchange and the quantity theory of money The financial sector and the real economy Moral hazard in banking Regulating the financial system Regulation and the money supply in a global economy Quantitative easing The money supply and monetary policy in an open economy The effectiveness of monetary policy

Fiscal Deficits and the National Debt

Topic overview The deficit and the debt: a flow and a stock What determines the size of a fiscal deficit Discretionary policy and automatic stabilisers Financing the deficit: bonds, borrowing and crowding out The benefits and costs of a deficit and of the national debt Fiscal policy, macroeconomic objectives and economic agents

Macroeconomic Policies and Objectives in a Global Economy

Topic overview Comparing the performance of different economies Global events and how they reach the domestic economy Responding to external demand and supply shocks Problems and constraints facing policymakers How the priority given to macroeconomic objectives has changed Comparing policies against one another

Quantitative Skills in Economics

Topic overview Ratios, shares and proportions in economic data Percentages and percentage changes in economic data Averages, medians and quantiles Index numbers, weighting and rebasing Converting money values to real values Cost, revenue and profit Elasticity: calculating the number and reading its meaning Choosing and reading economic charts and diagrams Interpreting economic data critically

Exchange Rate Systems and Competitiveness

9 subtopics
16 things to know
Unit A2 2

What Exchange Rate Systems and Competitiveness covers

Exchange rate systems and competitiveness is examined in Unit A2 2, Managing the Economy in a Global World. It covers how foreign exchange markets operate, the influences on currency demand and supply, monetary policy, intervention and other influences on the exchange rate, fixed and floating exchange rate systems, the Marshall-Lerner condition and the J-curve, the effect of exchange rate changes on the current account, trade-weighted exchange rate indices, purchasing power parity and comparing competitiveness and evaluating exchange rate policy.

Where it is assessed

Unit A2 2

Managing the Economy in a Global World, written examination, 30% of A level.

Check the CCEA specification ↗

The 9 subtopics

Each one has its own page.

What you need to know

Answer each one before you reveal it.

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Key term

Why is a single bilateral rate inadequate, and what is a trade-weighted exchange rate index?

Key term

What is purchasing power parity, and how do its absolute and relative forms differ?

Key term

Why does the supply curve of a currency slope upwards?

Key term

Analyse the effect of a large inflow of foreign direct investment on a country's exchange rate.

Key term

Why is a central bank's ability to support its own currency more limited than its ability to hold it down?

Key term

Analyse how a rise in the central bank's policy interest rate is transmitted to the exchange rate.

Key term

Explain what is meant by the policy trilemma facing an open economy.

Key term

Explain how a central bank maintains a fixed exchange rate when there is downward pressure on the currency.

Key term

What are the drawbacks of letting an exchange rate float freely?

Key term

Why are the price elasticities of demand for exports and imports typically low in the short run?

Key term

Analyse the effect of a currency depreciation on the current account of a country whose imports are mainly food, fuel and essential components.

Key term

Analyse the effect of a depreciation on a country's terms of trade.

Key term

Why might a depreciation fail to improve the current account even when the Marshall-Lerner condition is satisfied?

Key term

On what grounds would a country choose a fixed rate over a floating one, and what does it give up by doing so?

Key term

Analyse the costs of a policy of maintaining a strong exchange rate.

Key term

Evaluate the value of an exchange rate policy in achieving a sustainable balance of payments position.

Take Exchange Rate Systems and Competitiveness further

The same content, four other ways.

Questions from this topic

Each one with the model answer underneath.

1
What is a foreign exchange market?
Model answer
A foreign exchange market is the global network in which currencies are bought and sold against one another. It has no single physical location: banks, brokers, corporations, fund managers and central banks deal with each other electronically around the clock, with trading passing from one financial centre to another as the day moves round the world. The price established in it is the exchange rate, the amount of one currency that must be given to obtain a unit of another.
2
What determines the price of one currency against another in a floating market?
Model answer
The rate is set where demand for the currency equals its supply. Demand comes from foreigners buying the country's exports, from investors wanting its assets, and from speculators expecting it to appreciate; supply comes from residents buying imports, investing abroad, or selling the currency. Anything that shifts either side — relative interest rates, relative inflation, trade flows or expectations — moves the rate.
3
Who are the main participants in the foreign exchange market and why does each take part?
Model answer
Commercial banks and dealers make up the largest share of turnover, quoting prices to each other and to clients and managing their own positions. Firms take part because exporters receive foreign currency they need to convert and importers must buy foreign currency to pay suppliers. Investors and fund managers buy currency in order to purchase foreign shares, bonds and property. Tourists and migrants convert currency for travel and remittances. Speculators trade purely to profit from expected changes in the rate, and central banks intervene to influence the rate or manage reserves.
4
Explain how the exchange rate is determined in a freely floating market.
Model answer
The rate is set where the demand for the currency equals its supply. On a diagram with the exchange rate, say dollars per pound, on the vertical axis and the quantity of pounds traded on the horizontal axis, the demand curve for pounds slopes downward because a cheaper pound makes British goods and assets cheaper for foreigners, so more pounds are wanted. The supply curve of pounds slopes upward because a dearer pound buys more foreign currency, making foreign goods and assets cheaper for British residents, so more pounds are offered. Equilibrium is at the intersection, and any excess demand or supply moves the rate until the two are equal again.
5
Why does the demand curve for a currency slope downwards?
Model answer
A fall in the external value of the pound means that foreign buyers need fewer units of their own currency to obtain a pound, so British goods, services and assets become cheaper to them. They therefore buy more of these, and to do so they must buy more pounds. A lower price of the pound is thus associated with a larger quantity of pounds demanded, giving a downward-sloping curve. The reasoning is exactly the demand relationship applied to a currency, which is being treated as the good whose price is the exchange rate.
6
Why does the supply curve of a currency slope upwards?
Model answer
When the pound is worth more in foreign currency, each pound buys more foreign goods, services and assets, so British residents find imports and foreign investment cheaper and buy more of them. To do so they must sell pounds and buy foreign currency, so more pounds are supplied to the market. A higher price of the pound is therefore associated with a larger quantity of pounds supplied, giving an upward-sloping curve.

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Key Economic Concepts

The Basic Economic Problem of Scarcity and Choice

Demand and Supply in Product Markets

Markets and Equilibrium

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Exchange Rate Systems and Competitiveness revision questions

What does Exchange Rate Systems and Competitiveness cover in CCEA A-Level Economics?: 9 subtopics: how foreign exchange markets operate, the influences on currency demand and supply, monetary policy, intervention and other influences on the exchange rate, fixed and floating exchange rate systems, the marshall-lerner condition and the j-curve, the effect of exchange rate changes on the current account, trade-weighted exchange rate indices, purchasing power parity and comparing competitiveness and evaluating exchange rate policy. Each one has its own page with questions and model answers.
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