6.3 Foreign Exchange Rates

2026 Syllabus Objectives

By the end of this topic, you should be able to:

  • 6.3.1 Define a foreign exchange rate and understand the difference between floating and fixed exchange rate systems
  • 6.3.2 Explain how demand and supply of a currency determines the equilibrium exchange rate in the foreign exchange market
  • 6.3.3 Identify and explain the causes of exchange rate fluctuations, including changes in demand for exports/imports, interest rate changes, speculation, and the entry or departure of multinational companies (MNCs)
  • 6.3.4 Analyse the consequences of exchange rate fluctuations on export and import prices and spending, using Price Elasticity of Demand (PED)
  • 6.3.5 Compare the advantages and disadvantages of floating and fixed exchange rate systems

6.3.1 — What is a Foreign Exchange Rate?

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A foreign exchange rate is the price of one currency expressed in terms of another currency. In other words, it tells you how much of one currency you can get in exchange for another.

Example: If $1 = 280 PKR (Pakistani Rupees), it means one US Dollar can buy 280 Pakistani Rupees. This is the exchange rate between the dollar and the rupee.

Exchange rates matter because they affect:

  • How much imported goods cost
  • How competitive a country's exports are
  • How much tourists can buy when they travel abroad
  • Business decisions about investing in foreign countries

The Two Main Types of Exchange Rate Systems

1. Floating Exchange Rate System

In a floating exchange rate system, the value of a currency is determined entirely by the forces of demand and supply in the foreign exchange market (also called the "forex market"). The government does not interfere — the market sets the price naturally, just like prices for goods in any other market.

2. Fixed Exchange Rate System

In a fixed exchange rate system, the government (through its central bank) keeps the currency's value at a specific, set level called the official rate. The central bank actively buys and sells currency to prevent the rate from moving away from this fixed level.

6.3.2 — How is the Exchange Rate Determined?

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In a floating system, the exchange rate is determined by demand and supply — just like any product in a market.

Demand for a Currency

People from other countries demand (want to buy) a currency when they need it to:

  • Pay for goods and services exported from that country
  • Invest in that country's businesses or property
  • Visit that country as tourists
  • Earn profits or interest from investments in that country

The demand curve is downward-sloping. This means:

  • When the exchange rate is high (the currency is expensive), fewer people want to buy it → demand falls
  • When the exchange rate is low (the currency is cheap), more people want to buy it → demand rises

Supply of a Currency

A country's own residents supply (sell) their currency in the forex market when they need foreign currency to:

  • Buy imported goods and services
  • Invest money abroad
  • Travel to other countries
  • Take advantage of higher interest rates in foreign countries

The supply curve is upward-sloping. This means:

  • When the exchange rate is high, residents get more foreign currency per unit sold, so they are more willing to sell → supply rises
  • When the exchange rate is low, residents get less in return → supply falls

The Equilibrium Exchange Rate

The equilibrium exchange rate is the point where the quantity of currency demanded equals the quantity supplied. This is where the demand curve and supply curve intersect on a graph. At this point, the market is balanced — there is no shortage or surplus of the currency.

On a diagram:

  • Y-axis = Exchange Rate (price of the currency)
  • X-axis = Quantity of currency
  • The downward-sloping D curve meets the upward-sloping S curve at the equilibrium point (e1, Q1)

Shifts in the Demand Curve (Non-exchange rate factors)

The demand curve shifts right (increases) when:

  • Foreigners want more of the country's exports (they need to buy that currency to pay)
  • Interest rates in the country rise (attracting foreign investors)
  • Speculators expect the currency's value to rise (so they buy it now)
  • More foreign companies invest in the country (inward FDI — foreign direct investment flowing into the country)

The demand curve shifts left (decreases) when the opposite happens.

Shifts in the Supply Curve (Non-exchange rate factors)

The supply curve shifts right (increases) when:

  • Domestic residents import more goods (they sell their currency to buy foreign currency)
  • Interest rates abroad are higher (residents move money out of the country)
  • Speculators expect the currency's value to fall (they sell it quickly)
  • Domestic companies invest in other countries (outward FDI — investment flowing out of the country)

The supply curve shifts left (decreases) when the opposite happens.

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