Causes of foreign exchange rate fluctuations: changes in demand for exports and imports
International trade and globalisation – Foreign exchange rates
Imagine a giant marketplace where every country sells and buys goods. The price of a product in this market is not just in pounds, dollars or euros – it’s in foreign exchange rates (FX rates). These rates tell you how much of one currency you can get for another.
What is a foreign exchange rate?
A foreign exchange rate is the price of one currency expressed in terms of another. For example, if 1 £ = 1.30 USD, the FX rate between the pound and the dollar is 1.30.
Why do FX rates change?
Just like the price of a toy can rise or fall depending on how many kids want it, FX rates move because of the balance of demand and supply for different currencies. The main drivers are:
- Changes in export demand – more buyers for a country’s goods means more demand for that country’s currency.
- Changes in import demand – more buyers for foreign goods means more demand for foreign currencies.
- Interest rate differences, political events, and market sentiment also play roles.
Causes of FX fluctuations: Demand for exports & imports
Export demand rises ➜ more foreign buyers need the domestic currency ➜ domestic currency appreciates (gets stronger).
Export demand falls ➜ less foreign buyers need the domestic currency ➜ domestic currency depreciates (gets weaker).
Import demand rises ➜ domestic buyers need more foreign currency ➜ foreign currency appreciates, domestic currency depreciates.
Import demand falls ➜ domestic buyers need less foreign currency ➜ foreign currency depreciates, domestic currency appreciates.
Illustrative example
Suppose the UK exports cars to the US. If US demand for UK cars suddenly spikes (maybe because of a new car model), American buyers will need more pounds to pay for the cars. This increased demand for pounds pushes the £/USD rate higher (the pound strengthens).
| Scenario | Currency Demand | FX Rate Movement |
|---|---|---|
| UK car exports ↑ | US buyers ↑ demand for £ | £/USD ↑ (pound strengthens) |
| UK car imports ↓ | UK buyers ↓ demand for USD | £/USD ↑ (pound strengthens) |
Exam tip: Use the demand-supply logic
When answering questions about FX fluctuations, always:
- Identify the change in demand (exports or imports).
- Determine which currency’s demand increases.
- State whether that currency appreciates or depreciates.
Example: “If demand for UK exports rises, the pound will appreciate against the dollar.”
Quick quiz emoji style
📈 If the US suddenly needs more Japanese cars, which currency is likely to appreciate?
💡 Answer: The Japanese yen (¥) will appreciate against the dollar (USD) because more dollars are needed to buy yen.
Revision
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