Exchange Rates and the National Economy

What Exchange Rates and the National Economy covers

Exchange rates and the national economy is examined in Unit AS 2, Managing the National Economy. It covers 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 and evaluating the impact of exchange rate changes on output, employment, prices and agents.

The 5 subtopics

Each one has its own page. CCEA AS Economics students sit this topic in the first year.

• What an exchange rate is and how it is measuredExchange rate, appreciation and depreciation of a currency mean and strong currency make imports cheap and exports dear.Open →
• Exchange rate changes in the AD-AS modelAD-AS diagram showing the demand-side effect of a depreciation and AD-AS diagram showing the supply-side effect of a depreciation.Open →
• Holding the exchange rate above or below the market clearing levelOvervalued exchange rate affect the domestic price level, undervalued exchange rate affect import prices and living standards and persistently undervalued currency lead to friction with trading partners.Open →
• Why a government might have an exchange rate policyExchange rate policy, government want a stronger currency and government want a weaker currency.Open →
• Evaluating the impact of exchange rate changes on output, employment, prices and agentsEffect of a depreciation on real output, effect of a depreciation on employment and effect of a depreciation on households as consumers.Open →

What you need to know

Answer each one before you reveal it.

Take Exchange Rates and the National Economy further

The same content, four other ways.

Commonly confused

Pairs that lose marks when they are blurred together.

• Appreciation vs Depreciation

  Appreciation: the currency buys more foreign currency. Depreciation: a currency buying less foreign currency.

Questions from this topic

Each one with the model answer underneath.

1. 1

   What is an exchange rate?

   Model answer

   An exchange rate is the price of one currency expressed in terms of another, for example the number of United States dollars that one pound will buy. Like any price it tells you what has to be given up to obtain something, so it converts prices in one country into prices that buyers in another country actually face. Because almost every internationally traded good, service and asset has to be paid for in the seller’s currency, the exchange rate acts as a link between the domestic price level and the prices faced by foreign customers and suppliers.

2. 2

   What do appreciation and depreciation of a currency mean?

   Model answer

   An appreciation is a rise in the value of a currency against another, so a unit of the domestic currency buys more foreign currency than before. A depreciation is a fall in its value, so a unit of the domestic currency buys less foreign currency. If the pound moves from 1.20 to 1.30 United States dollars it has appreciated, and if it moves from 1.20 to 1.10 dollars it has depreciated.

3. 3

   The exchange rate is 1 pound = 1.25 United States dollars. Calculate how many dollars 4,000 pounds converts to, and how many pounds 3,000 dollars converts to.

   Model answer

   To convert pounds into dollars, multiply by the rate: 4,000 times 1.25 = 5,000 dollars. To convert dollars into pounds, divide by the rate: 3,000 divided by 1.25 = 2,400 pounds. The rule is to multiply when moving in the direction the rate is quoted and to divide when moving against it.

4. 4

   A car made in the United Kingdom sells for 40,000 pounds. Calculate its price to a United States buyer when the exchange rate is 1 pound = 1.25 dollars and again after sterling depreciates to 1 pound = 1.10 dollars, and find the percentage change.

   Model answer

   At 1.25 dollars to the pound the car costs 40,000 times 1.25 = 50,000 dollars. At 1.10 dollars to the pound it costs 40,000 times 1.10 = 44,000 dollars. The fall is 6,000 dollars, which is 6,000 divided by 50,000 = 0.12, or 12%, and this matches the 12% fall in the exchange rate from 1.25 to 1.10, since the foreign-currency price of an unchanged sterling price moves in exact proportion to the rate. The United Kingdom exporter has become cheaper in the American market without changing its own price.

5. 5

   A British firm imports a machine priced at 30,000 euros. Calculate its cost in pounds when the rate is 1 pound = 1.20 euros and again after sterling falls to 1 pound = 1.00 euro, and state the percentage increase in cost.

   Model answer

   At 1.20 euros to the pound the machine costs 30,000 divided by 1.20 = 25,000 pounds. At 1.00 euro to the pound it costs 30,000 divided by 1.00 = 30,000 pounds. The increase is 5,000 pounds, which is 5,000 divided by 25,000 = 0.20, or 20%, so a fall in sterling raises the domestic cost of imported capital equipment and squeezes the firm's margins or forces it to raise its own prices.

6. 6

   What is an effective or trade-weighted exchange rate, and why is it more useful than a single bilateral rate?

   Model answer

   An effective exchange rate is an index of a currency’s value against a basket of the currencies of its main trading partners, with each currency weighted according to its share in that country’s trade. It is more useful than a single rate because a currency can rise against one partner while falling against another, so a bilateral rate can give a completely misleading impression of overall competitiveness. The index summarises the net effect on the prices faced by the country’s exporters and importers as a whole.

What is inside Levo

Six ways to work the same material.

Exchange Rates and the National Economy revision questions

Is Exchange Rates and the National Economy examined at AS in CCEA Economics?

Yes. It sits in Unit AS 2, which you take in the first year, so it is on the AS paper as well as counting towards the full A level.

What does Exchange Rates and the National Economy cover in CCEA AS-Level Economics?

5 subtopics: 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 and evaluating the impact of exchange rate changes on output, employment, prices and agents. Each one has its own page with questions and model answers.

How is Exchange Rates and the National Economy organised?

By the CCEA 4410 specification, subtopic by subtopic, so it matches the order you are taught it in.