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Exchange Rates and the Balance of Payments (A Level Economics)

An exchange rate is the price of one currency in another. £1 = $1.50 means a pound buys a dollar and a half. Exchange rates (A Level Economics) are taught as a demand and supply diagram for the pound, and the balance of payments is the account that records what the rate does to trade. This page covers the currency diagram, the three exchange rate systems, what makes the pound rise or fall, what a fall does to prices, inflation and growth, the balance of payments and its current account, the J-curve and the Marshall-Lerner condition, a worked example in pounds and dollars and three exam-style questions with the answers derived.

Spec map: where exchange rates and the balance of payments sit on your board

Board Where it sits Papers that test it
AQA 7136 4.2.6.3 the balance of payments: the current, capital and financial accounts, the four parts of the current account, the meaning of a deficit and a surplus, the factors behind the balance (productivity, inflation, the exchange rate), investment flows (FDI against portfolio investment), the policies that correct an imbalance including “expenditure-switching and expenditure-reducing”, and the global effects. 4.2.6.4 exchange rate systems: how a floating rate is determined, government intervention, fixed against floating, and the case for and against joining a currency union such as the eurozone Paper 2, Paper 3
Edexcel 9EC0 4.1.7 balance of payments (the components; causes of current-account deficits and surpluses; measures to reduce an imbalance; global imbalances). 4.1.8 exchange rates: floating, fixed and managed systems, revaluation against appreciation, devaluation against depreciation, the factors behind a floating rate, intervention “through foreign currency transactions and the use of interest rates”, competitive devaluation, and the impact of a change on the current account “with reference to Marshall-Lerner condition and J curve effect”, growth, unemployment, inflation and FDI. 4.1.9 international competitiveness Paper 2, Paper 3
OCR H460 Component 02: 2.5 balance of payments (the components of the current account, a sustainable position as an objective, “explain and calculate” the balances, causes and consequences of imbalances). 4.2 exchange rates: “explain and calculate”, determination in fixed and floating systems with a diagram, causes and consequences of changes, the systems compared. 4.3 globalisation names the “Marshall-Lerner condition and J-curve” and international competitiveness Component 02, Component 03
Cambridge International 9708 AS 6.3 the current account (components, calculating the balances, causes and consequences of imbalances), 6.4 exchange rates (a floating rate, appreciation and depreciation, the causes, AD/AS analysis of a change) and 6.5 policies to correct a current-account imbalance. A Level 11.1 the full balance of payments with the financial and capital accounts, expenditure-switching against expenditure-reducing, and 11.2 nominal, real and trade-weighted rates, fixed and managed systems, revaluation and devaluation, “Marshall-Lerner and J curve analysis” Paper 1 and 2 (AS), Paper 3 and 4 (A Level)

Section numbers are from the AQA specification (the PDF numbers these 4.2.6.3 and 4.2.6.4, the web version 3.2.6.3 and 3.2.6.4), the Edexcel specification (Issue 2), the OCR specification (v3.0, June 2026) and the Cambridge syllabus for 2026 to 2028, all checked in September 2026. The AQA content list does not name the J-curve or Marshall-Lerner; the other three boards do. The AD/AS side of a change in the rate is on the aggregate demand and aggregate supply page.

What you must be able to do

The currency diagram: demand for and supply of pounds

Draw it like any other market. The good is the pound. The price is what a pound costs in another currency, usually dollars. Demand for pounds comes from people abroad who need them: to buy UK exports, to holiday here, to buy UK shares, bonds and property, or to bet that the pound will rise. Supply of pounds comes from people in the UK selling them: to buy imports, to holiday abroad, to invest abroad, or to bet the other way.

Exchange rate diagram: a fall in demand for pounds depreciates the pound Price of £1 (in $) Quantity of pounds traded (£bn) E₁ E₂ D₁ for £ D₂ S of £ fewer pounds wanted 70 40 $1.50 $1.20
Figure 1 — Exchange rate diagram, the market for pounds: demand for sterling falls from D₁ to D₂, so the pound depreciates from $1.50 to $1.20 and the quantity traded falls from £70bn to £40bn.

In figure 1 demand for pounds falls. Perhaps the Bank of England has cut interest rates, so foreign savers move their money elsewhere. Perhaps a recession abroad has cut demand for UK exports. Either way fewer pounds are wanted at every price, D₁ shifts to D₂, and the equilibrium price of the pound falls from $1.50 to $1.20. That is a depreciation of 20%. A rise in demand, or a fall in supply, does the opposite: an appreciation.

Key terms: In a floating system the currency appreciates (rises) or depreciates (falls) because the market moves it. In a fixed system the government revalues or devalues it by decision. Use the right pair or lose the knowledge mark.

Mark scheme: Label the vertical axis “price of £ in $” (or euros), the horizontal axis “quantity of pounds”, the curves D for £ and S of £, and the equilibria. Show the change as a shift with an arrow and name the cause on the diagram: “D₁ to D₂: interest rates cut, hot money leaves”. A diagram with the right axes and one shift is usually 4 marks.

Floating, fixed and managed exchange rates

System Who sets the rate How it is held Example For Against
Floating The market: demand and supply, all day Nobody holds it; it moves The pound, the dollar, the euro against each other Adjusts on its own: a current-account deficit weakens the currency, which helps correct it. No reserves needed. Monetary policy is free for the domestic economy Volatile: firms cannot plan prices; speculation can drive it far from where trade would put it
Fixed (a peg) The government or central bank, at a target Buying and selling reserves of foreign currency, and moving interest rates, to hold the target The Hong Kong dollar pegged to the American dollar; the pound in the ERM until 1992 Certainty for trade and investment; imports of inflation are blocked; discipline on domestic policy Needs large reserves; interest rates serve the peg, not the economy; a peg that looks wrong invites a speculative attack
Managed (dirty float) The market, but the central bank steps in when it wants to Occasional intervention and rate changes to slow or cap a move Many emerging economies; China’s yuan against a basket The middle way: some flexibility, some stability Never sure which way the bank will lean; can become a fixed rate by another name

Currency union is the extreme fixed case: the eurozone countries share one currency, so between them the rate is one for ever. The exam evaluation is the same as for a peg, plus one loss: no exchange rate to adjust when one member’s costs get out of line.

What makes the pound rise or fall

Every cause works through the diagram. Ask: does it change the demand for pounds, or the supply?

Cause What happens to the pound Why
Interest rates rise (relative to abroad) Appreciates Foreign savers buy pounds to earn the higher return: “hot money” flows in, demand rises
Inflation higher than abroad Depreciates UK goods get dearer, exports fall, imports rise: demand for pounds falls, supply rises. Purchasing-power parity says the rate falls to compensate
Strong growth and confidence Usually appreciates Foreign firms invest here (FDI), and expected returns rise. But growth also sucks in imports, which cuts the other way
A current-account deficit Depreciates, over time More pounds are sold for imports than are bought for exports
Speculation Either Traders buy what they expect to rise; expectations move the rate before anything real does
Quantitative easing Depreciates More pounds in circulation and lower long-term interest rates
Political shocks Usually depreciates Uncertainty makes investors sell first and ask later. The referendum result in June 2016 is the example every examiner knows

What a depreciation does: prices, inflation, growth and the current account

The mnemonic is SPICED: a Strong Pound makes Imports Cheaper and Exports Dearer. Reverse it for a weak pound. Use figure 1’s numbers. Before the fall a £50 UK jumper costs an American $75. After it, $60. UK exports are 20% cheaper abroad without any UK firm cutting a price. A pair of American trainers priced at $60 cost a UK shopper £40 before and £50 after. Imports are 25% dearer in pounds.

Effect of a depreciation Direction Chain of reasoning
Exports Rise Cheaper in foreign currency, so foreign buyers buy more (how much more depends on PED)
Imports Fall Dearer in pounds, so UK buyers switch to UK-made substitutes where they can
Aggregate demand Rises Net exports (X − M) are part of AD; AD shifts right, real GDP and employment rise
Inflation Rises Imported raw materials and finished goods cost more (cost-push), and higher AD adds demand-pull
Current account Worse first, better later The J-curve, below
Living standards Fall in the short run Every pound buys less abroad: holidays, fuel, food and phones cost more
Foreign investment Mixed UK assets are cheaper to buy, but returns in foreign currency are lower

Exam tip: The strength of every effect depends on elasticity. If demand for UK exports is price inelastic, a cheaper pound raises volumes only a little and export revenue in pounds can even fall. Say “it depends on the price elasticity of demand for exports and imports” and you have the evaluation the mark scheme is waiting for.

The balance of payments: current, capital and financial accounts

The balance of payments records every transaction between UK residents and the rest of the world in a year. Money in is a credit; money out is a debit. The whole thing balances by definition: a current-account deficit is financed by a surplus on the financial account, because the pounds spent on imports come back as foreign purchases of UK assets.

Account What is in it Example
Current account: trade in goods Exports minus imports of physical goods (the “balance of trade in goods”) Cars, pharmaceuticals, food, oil
Current account: trade in services Exports minus imports of services Finance, insurance, education, tourism, consulting
Current account: primary income Income earned on assets abroad minus income paid to foreign owners of UK assets Dividends, interest, profits of UK firms abroad
Current account: secondary income Transfers with nothing bought in return Aid, remittances, contributions to international bodies
Capital account Small: transfers of capital and non-produced assets Debt forgiveness, sale of patents
Financial account Purchases and sales of assets between countries FDI (a factory), portfolio investment (shares and bonds), bank deposits, changes in reserves

The UK runs a current-account deficit most years, and the exam wants the causes: a high propensity to import, weak competitiveness and productivity, a strong pound at times, and strong consumer demand relative to trading partners. The examiner also wants you to say whether it matters. A deficit financed by long-term investment into the UK is not a crisis. One financed by short-term borrowing that could leave overnight is.

The policies split two ways. Expenditure-switching policies move spending from imports to UK goods: a lower exchange rate, or tariffs. Expenditure-reducing policies cut spending on everything, imports included: higher interest rates, higher taxes, lower government spending. And supply-side policies raise competitiveness so exports win on quality and price without any of that. Each has a cost to another objective, which is the essay.

The J-curve and the Marshall-Lerner condition

A depreciation should improve the current account. It does, but not at first. Prices change on the day; volumes take months. The import bill goes up immediately, because each dollar of imports now costs 25% more in pounds, while the quantity of imports barely moves. Foreign buyers take time to notice the cheaper price, switch suppliers and sign new contracts. So the deficit gets worse before it gets better. Plotted against time the balance traces the letter J.

The J-curve: the current account after a depreciation Current account balance (£bn) Months after the fall in the pound 12 24 36 0 -20 −40 trough: about −£30bn at month 3 starting deficit £20bn back to −20 at month 9 surplus from month 28 heading for +£5.5bn prices change at once, volumes catch up slowly
Figure 2 — J-curve diagram: after a 20% depreciation the current account, starting at a £20bn deficit, worsens to about £30bn after about three months, is back at £20bn after about nine months, moves into surplus after about 28 months and heads for a £5.5bn surplus as the long-run elasticities take over.

The Marshall-Lerner condition says when the improvement arrives. A depreciation improves the current account only if the price elasticities of demand for exports and for imports add up to more than one (ignoring the signs). In the short run they are small, the sum is below one and the balance worsens. In the long run people adjust, the sum passes one and the balance improves. In figure 2 the long-run elasticities are 0.9 for exports and 1.0 for imports. Their sum is 1.9, so the balance ends in surplus.

Common mistake: Writing “a depreciation improves the current account” as if it were automatic. Two conditions are needed: enough time for volumes to respond (the J-curve) and elasticities that add to more than one (Marshall-Lerner). A country whose exports are commodities with inelastic demand can devalue and still get worse.

Worked example — a 20% fall in the pound, from the shop shelf to the current account

The pound falls from $1.50 to $1.20 (figure 1). Before the fall the UK exports £100bn of goods and services and imports £120bn. Long-run elasticities: 0.9 for exports, 1.0 for imports.

  1. The depreciation: (1.20 − 1.50) ÷ 1.50 = −20%. The pound is 20% cheaper.
  2. Export prices abroad: a £50 jumper was 50 × 1.50 = $75. Now 50 × 1.20 = $60. That is 20% cheaper for the American buyer. UK exporters have changed nothing.
  3. Import prices at home: $60 trainers were 60 ÷ 1.50 = £40. Now 60 ÷ 1.20 = £50. Imports are 25% dearer in pounds, not 20%, because 1 ÷ 0.8 = 1.25.
  4. Day one: volumes have not moved. Exports are still £100bn. The import bill heads towards 120 × 1.25 = £150bn as the new prices reach the shops. The deficit widens from £20bn towards £30bn (figure 2 bottoms at about £30bn around month three).
  5. The long run: foreign buyers respond to the 20% price cut with elasticity 0.9, so export volumes rise by 0.9 × 20% = 18%. Exports become 100 × 1.18 = £118bn.
  6. UK buyers respond to the 25% price rise with elasticity 1.0, so import volumes fall 25%. The import bill becomes 150 × 0.75 = £112.5bn.
  7. The long-run balance: 118 − 112.5 = +£5.5bn. A surplus. Figure 2 crosses zero after about 28 months and is still climbing towards £5.5bn at the three-year mark.
  8. The check: elasticities 0.9 + 1.0 = 1.9 > 1, so Marshall-Lerner holds and the surplus is what the theory predicts. Had the elasticities summed to less than one, the current account would have stayed worse than £20bn for good.

Exam-style questions

Q1: The pound falls from €1.20 to €1.08. Calculate the percentage change in the exchange rate and the new euro price of a UK hotel room that costs £200. (4 marks)
A: Change = (1.08 − 1.20) ÷ 1.20 × 100 = −10%: a 10% depreciation (2). The room was 200 × 1.20 = €240 (1); it is now 200 × 1.08 = €216, so UK tourism is 10% cheaper for a French visitor (1).

Q2: In the short run the price elasticities of demand for a country’s exports and imports are 0.4 and 0.3. In the long run they are 0.9 and 1.0. Explain what happens to the current account after a depreciation. (6 marks)
A: Marshall-Lerner: a depreciation improves the current account only if the two elasticities sum to more than one (1). Short run: 0.4 + 0.3 = 0.7 < 1, so the condition fails (1). Import prices rise at once while volumes barely change, so the import bill rises and the deficit widens (1). Long run: 0.9 + 1.0 = 1.9 > 1, so the condition holds (1). Volumes respond: exports rise, imports fall, and the balance improves past its starting point (1). The path is the J-curve: worse first, better later (1).

Q3: Evaluate the view that a depreciation of the pound is good for the UK economy. (25 marks)
A: Develop two arguments on either side before you reach a judgement.

Examiner’s checklist: the mistakes that lose exchange-rate marks

Key takeaways

FAQ

Q: What is the balance of payments at A Level Economics?
A: The record of all money flowing between one country and the rest of the world in a year, split into the current account (trade in goods and services, primary and secondary income), the capital account and the financial account (investment flows). The current account is the part the exam asks about most.

Q: What causes a current account deficit at A Level?
A: Imports outrunning exports over a period: a high propensity to import, weak productivity and competitiveness, an overvalued currency, strong consumer demand relative to trading partners, or a fall in income earned abroad. The examiner wants two causes explained and a view on whether the deficit matters.

Q: What is the J-curve in economics?
A: The path the current account follows after a depreciation: worse first, because prices change before volumes, then better as buyers respond. It is drawn as the balance against time and looks like a J. Figure 2 shows one with the trough at about three months and the surplus arriving after about 28.

Q: What is the Marshall-Lerner condition?
A: A depreciation improves the current account only if the price elasticities of demand for exports and for imports add up to more than one. In the short run they usually do not, which is why the J-curve dips before it rises.

Q: What is the difference between depreciation and devaluation?
A: Both mean the currency is worth less. A depreciation happens in a floating system when the market moves the rate. A devaluation is a government decision to lower a fixed rate. The same split applies to appreciation and revaluation.

Q: Which questions come up on exchange rates?
A: A percentage-change or price calculation for 2 to 4 marks, “explain, using a diagram, the effect of a rise in interest rates on the exchange rate” for 4 to 8 marks, and a 15 or 25-mark evaluation of a depreciation or of policies for a current-account deficit. Paper detail is on the AQA, Edexcel and OCR pages; the trade side is on the international trade and protectionism page, the interest-rate link on the monetary policy page, and the revision hub lists the rest of the macro topics.

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