What moves floating exchange rates

Factors

• Relative interest rates: higher rates attract inflows, raising demand (appreciation).
• Relative inflation rates and purchasing power parity (PPP): if a country's inflation is higher than its trading partners', its exports become less competitive and demand for its currency falls. PPP theory says that in the long run exchange rates adjust so the same basket of goods costs the same in each country.
• The current account: a surplus means net demand for the currency from exports; a deficit means net supply.
• Economic strength: strong growth and stable policies attract FDI.
• Capital flight: large, sudden outflows when investors lose confidence (political crisis, default risk) cause a sharp depreciation.
• Expectations and speculation: if traders expect a rise, they buy now, which makes the rise happen.
• Global factors: for example a fall in commodity prices reduces demand for the currencies of commodity exporters.

Converting currencies

If £1 = $1.25:

• pounds to dollars: multiply by 1.25 (£80 = $100);
• dollars to pounds: divide by 1.25 ($100 = £80).

The rate can be quoted either way: £1 = $1.25 is the same as $1 = £0.80.

Percentage change in a currency: (new rate - old rate) / old rate x 100, using the rate quoted as foreign currency per unit of that currency.

PPP calculation

PPP rate = price of basket in country B's currency / price in country A's currency. If a basket costs £5.00 in the UK and $6.50 in the US, the PPP rate is $1.30 per £. If the market rate is $1.25, the pound buys less than PPP suggests: it is undervalued against the dollar by (1.25 - 1.30) / 1.30 x 100.

Worked example

A basket costs £5.00 in the UK and $6.50 in the US. The market rate is £1 = $1.25. Find the PPP rate and the over- or undervaluation of the pound.

1. PPP rate = 6.50 / 5.00 = $1.30 per £
2. (1.25 - 1.30) / 1.30 x 100 = -3.85%

Answer: The pound is undervalued by about 3.85%

Check yourself

1. £1 = $1.25. Convert £640 into US dollars.
   Show answer

   $800. 640 x 1.25 = $800.

2. £1 = $1.25. Convert $450 into pounds.
   Show answer

   £360. 450 / 1.25 = £360.

3. The rupee moves from 83 rupees per US dollar to 86 rupees per US dollar. Calculate the percentage change in the value of the rupee in dollars, to 2 decimal places (negative for a fall).
   Show answer

   -3.49 %. Value of 1 rupee: 1/83 to 1/86 dollars. Change = (83/86 - 1) x 100 = -3.49%.

4. A UK car is priced at £20,000. The exchange rate falls from £1 = €1.20 to £1 = €1.10. By how many euros does the car's price in the eurozone fall?
   Show answer

   €2000. 24,000 - 22,000 = €2,000.

5. A basket costs 300 yuan in China and $60 in the US. Calculate the PPP exchange rate in yuan per dollar.
   Show answer

   5 yuan per $. 300 / 60 = 5 yuan per dollar.

6. Country R's inflation rate is persistently higher than its trading partners'. According to PPP theory, R's currency will
   • appreciate
   • stay constant
   • become fixed
   • depreciate
   Show answer

   depreciate. Its goods become dearer, so demand for its currency falls until prices are equalised.

7. Which is most likely to cause sudden capital flight from an emerging economy?
   • A rise in its interest rates
   • Fears that the government will default on its debt
   • A current account surplus
   • Strong economic growth
   Show answer

   Fears that the government will default on its debt. Loss of confidence leads investors to pull money out quickly.

8. Explain how speculation can cause a currency to appreciate.
   Show answer

   If speculators expect the currency to rise, they buy it now to make a profit; this increases demand for the currency, so it appreciates (a self-fulfilling expectation).. Expectations change demand today.

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Sources

• Pearson Edexcel International Advanced Level in Economics specification (issue 2)

Last updated 8 November 2026. Spotted a mistake? Tell us.