Cambridge Syllabus Notes

International Trade and Globalisation – Foreign Exchange Rates

Objective: Determination of the Equilibrium Foreign Exchange Rate

In the FX market, the equilibrium rate is the price at which the quantity of a currency that buyers want to purchase equals the quantity that sellers want to sell. Think of it as the “fair price” where no one wants to trade more or less.

1. What is a Foreign Exchange Rate? 💱

The foreign exchange rate tells you how many units of one currency you can get for one unit of another currency. For example, if 1 USD = 0.75 GBP, you can exchange 1 US dollar for 0.75 British pounds.

2. Supply and Demand in the FX Market 📈

Just like any market, the FX market has supply and demand:

Supply of foreign currency: When domestic consumers want foreign goods, they need foreign currency, so they supply it to the market.
Demand for foreign currency: When foreign consumers want domestic goods, they demand domestic currency, which means they supply foreign currency to the market.

Analogy: Imagine a market where apples (domestic) and oranges (foreign) are traded. If many people want oranges, the price of oranges rises.

Quantity of Currency (units)	Exchange Rate (domestic per foreign)
High	Low
Low	High

3. Finding the Equilibrium Rate ⚖️

Write the demand equation for the foreign currency: $D = a - bE$
Write the supply equation for the foreign currency: $S = c + dE$
Set demand equal to supply: $a - bE = c + dE$
Solve for $E$ (the equilibrium exchange rate): $E = \dfrac{a - c}{b + d}$
Check that the resulting $E$ makes sense in the context of the market.

4. Example: UK & US Exchange Rate 🇬🇧🇺🇸

Suppose:

Demand for GBP: $D = 5000 - 200E$
Supply of GBP: $S = 3000 + 150E$

Set $D = S$:

$$5000 - 200E = 3000 + 150E$$

Combine terms:

$$5000 - 3000 = 200E + 150E \;\;\Rightarrow\;\; 2000 = 350E$$

So the equilibrium rate is:

$$E = \dfrac{2000}{350} \approx 5.71$$

This means 1 GBP ≈ 5.71 USD at equilibrium.

5. Exam Tips for the IGCSE Economics Paper 📚

Always label supply and demand curves clearly.
Show the algebraic steps when solving for the equilibrium rate.
Use the word “equilibrium” to highlight the point where supply equals demand.
Remember that a higher supply of foreign currency tends to depreciate that currency.
Check your units: if you’re using £ and $, the rate should be in £ per $ or vice‑versa.

The determination of the equilibrium foreign exchange rate