Explain why the value of a currency may fall in a floating exchange rate system

AQA A-Level Economics June 2019 - 15 Marks Model Answer

Exchange rate is the price of currency in terms of another. A floating exchange rate is when the exchange rate is determined only by supply and demand of the currency.

One factor that can devalue the currency is lower interest rates. Interest rates are the cost of borrowing or the reward for saving. When a country has low interest rates, the reward for saving in the UK is lower so there would be less hot money flows into the UK of people wanting to save in the UK currency, as there is less reward. Therefore, there would be less demand for the Pound, so demand for the Pound would shift to the left, so the value of the Pound would decrease as shown by the diagram below. Also, people may want to save money in other countries, where the interest rates are higher, so they may sell the Pound in order to buy the other currency. This would cause supply of the Pound to increase, also causing the value of the Pound to fall further.

DEMAND FOR POUND SHIFTS TO THE LEFT

Another factor that can devalue the currency is if there is an increase in the value of imports. If imports increase, then the supply of pounds will increase since as consumers would need to sell pounds in order to buy a different currency to import from, therefore the supply of the pound is increase from s1 to s2, causing a decrease in the value of the pound from P1 to P2. The diragram below shows that as supply shifts right, the equilibrium quantity falls from Q1 to Q2, and the price of the Pound decraeses from P1 to P2.

SUPPLY FOR POUND SHIFTS TO THE RIGHT

Imports could increase for various reasons, such as a poor supply-side in the UK economy or due to high economic growth, causing an increase in taste for expensive imports.