Floating, fixed and managed regimes, devaluation versus depreciation, and the Marshall-Lerner condition, with the evaluation that earns the top marks.
Why do some countries fix their currency and others let it float?
A floating rate is set by supply and demand and leaves interest rates free for domestic goals. A fixed rate gives stability but means giving up independent monetary policy and holding reserves. Managed floats sit between the two. Whether a devaluation helps depends on elasticities and time.
The exchange rate is the price of one currency in terms of another. For example, £1 might buy $1.30. An exchange rate system is the set of rules a country uses to determine that price.
The rate is set by the demand for and supply of the currency in the foreign exchange (forex) market. The central bank does not try to hit a target rate. Interest rates can be set for domestic goals such as the inflation target.
The government or central bank commits to a set rate, or a narrow band, against another currency. To hold it, the central bank buys or sells the currency using its foreign exchange reserves, which are its stock of foreign currency. It may also change interest rates.
The rate moves with the market, but the central bank intervenes to smooth sharp swings or lean towards a preferred level. Most economies sit somewhere on this spectrum, whatever label they use.
Figure 1 shows a currency pegged at P0. Demand for the currency then falls, perhaps because investors expect weaker growth. At P0 there is now excess supply of the currency.
The central bank must buy its own currency to hold the peg. It pays with foreign reserves, so reserves fall. It could also raise interest rates to attract foreign savers, but that slows the economy.
If reserves run low, the peg may break. The government then devalues, or lets the currency float. Traders who expect this sell the currency early, so the pressure grows.
A lower rate makes exports cheaper abroad and imports dearer at home. Whether the trade balance improves depends on how far quantities respond. That is the Marshall-Lerner condition.
Elasticities are usually low in the short run, because contracts are fixed and buyers cannot switch at once. So the trade deficit can widen first, then narrow later. This pattern is the J-curve.
Illustrative figures: a currency falls from $1.30 to $1.20 per £1. That is a fall of 0.10 ÷ 1.30 = 7.7%. If PED of exports is 0.4 and of imports is 0.3, the sum is 0.7. That is below 1, so the deficit worsens. In the long run the elasticities might be 0.9 and 0.7, giving 1.6, so the balance improves.
A fixed rate gives firms and households certainty about import costs and export prices. It can also build credibility for a country with a history of high inflation, because the anchor country's discipline is borrowed. The cost is that monetary policy follows the anchor country.
Hong Kong shows this clearly. Its currency is held in a band against the US dollar, and the HKMA (Hong Kong Monetary Authority, its central bank) commits to buy or sell at the band edges.[1] Its base rate then tracks the US rate, whatever Hong Kong's own cycle needs.[7]
A floating rate absorbs shocks automatically. If demand for exports falls, the currency can fall and cushion the blow. The cost is volatility, which raises risk for importers and exporters and can feed imported inflation.
Evaluation turns on these points:
The Swiss case shows the time-horizon point. The Swiss National Bank (SNB) held a floor of CHF 1.20 per euro from September 2011 to January 2015. It dropped the floor when holding it needed ever larger interventions.[3]
Most lost marks come from loose terms and one-sided chains. Check each of these before you write.
For a policy question, finish with a judgement. State which regime suits which type of economy, and why.
The economics is the same on every board; the question format is what changes. Most questions on this topic take one of six shapes. Open each to see how the topic appears in it and what earns the marks. All questions here are original Curriculum Circle practice questions, not board questions.
On this topicVery common. Expect definitions (devaluation versus depreciation) and quick applications of the Marshall-Lerner condition.
What earns the marksAO1 for definitions, with AO2 when you apply a number to a rate change.
CC practice questionA currency is pegged. Which action can the central bank take to defend the peg when demand for the currency falls? A. Sell foreign reserves and buy the currency. B. Cut interest rates. C. Buy foreign reserves with the currency. D. Remove the peg. (1 mark)
On this topicAppears as a percentage change in the exchange rate, or a check of the Marshall-Lerner condition from two PED values.
What earns the marksAO1 for the formula and AO2 for applying it and interpreting the answer.
CC practice questionIllustrative figures: the price of £1 falls from €1.20 to €1.14. Calculate the percentage change in the exchange rate. Then state whether the Marshall-Lerner condition holds if PED of exports is 0.6 and PED of imports is 0.5. (3 marks)
On this topicCommon. Asks why a country might peg, or why a depreciation may not improve the current account at first.
What earns the marksAO1 for the terms, AO2 for context and AO3 for a short chain of reasoning.
CC practice questionExplain why a devaluation may worsen a country's current account deficit in the short run. (6 marks)
On this topicOften a forex diagram with a shift in demand or supply, or a peg defended with reserves, followed by effects on trade and inflation.
What earns the marksAO2 for diagram and context and AO3 for the chain of cause and effect.
CC practice questionUsing a diagram, analyse how a central bank would defend a fixed exchange rate when demand for its currency falls. (9 marks)
On this topicThe usual home for this topic: assess a policy such as joining a peg, devaluing, or intervening in the forex market, using an extract or data.
What earns the marksAO3 for the analysis and AO4 for a judgement based on size of reserves, elasticities and time.
CC practice questionUsing the extract, assess whether a government should abandon its currency peg and allow the currency to float. (12 marks)
On this topicAppears as a comparison of regimes or a test of devaluation as a policy for a trade deficit.
What earns the marksAll four AOs. AO4 decides the top band through a conditional, supported judgement.
CC practice question'A floating exchange rate is always better for an economy than a fixed one.' Discuss. (25 marks)
| Weight | What it is | What it means on exchange rate systems | |
|---|---|---|---|
| AO1 | 20–23% | Knowledge and understanding of terms, concepts, theories and models | Know the three systems, the difference between devaluation and depreciation, and the Marshall-Lerner condition. Define terms precisely. |
| AO2 | 26–29% | Application to economic contexts | Apply the ideas to a named economy or to data in an extract, such as a peg, a band or a change in reserves. |
| AO3 | 26–29% | Analysis of issues and their impact on economic agents | Build chains: demand for the currency falls, reserves are used, interest rates rise or the peg breaks, and trade and inflation respond. |
| AO4 | 22–25% | Evaluation, using evidence to reach a judgement | Weigh stability against policy freedom. Judge using reserves, elasticities, credibility and time, then give a supported conclusion. |
Weightings are approximate and taken from the AQA A-level Economics 7136 specification [0]. Edexcel and IAL weight the objectives differently, but they test the same four skills.
Assess whether a country with a persistent current account deficit should devalue its pegged currency.
A devaluation lowers the foreign price of exports and raises the home price of imports. If the Marshall-Lerner condition holds, export revenue rises by more than import spending, so the current account improves. Demand for exports also adds to aggregate demand, so output and jobs rise.
In the short run, elasticities are low because contracts are fixed. Import spending in home currency rises, so the deficit may widen first. This is the J-curve. Dearer imports also raise costs for firms, so inflation may rise and erode the price advantage.
The outcome depends on elasticities, spare capacity and time. If the country exports differentiated goods with few substitutes, elasticity may stay low, so devaluation helps little. If there is spare capacity, firms can raise output without raising prices, so the gain lasts longer. If the economy relies on imported inputs, cost-push inflation can cancel the gain within a year or two.
A devaluation also admits that the peg failed, which can hurt credibility and push up borrowing costs. My judgement is that devaluation is justified only when the deficit comes from an overvalued rate, and the elasticities sum to more than 1 in the long run. Otherwise supply-side reform is a better route, because it improves competitiveness without raising import prices.
Hong Kong has linked its dollar to the US dollar since 17 October 1983.[2] The HKMA stands ready to sell Hong Kong dollars at 7.75 and buy them at 7.85 per US dollar.[1] On 29 October 2026 it held its base rate at 4.25%, following the US Federal Reserve.[7]
From 6 September 2011 to 15 January 2015, the Swiss National Bank held a minimum rate of CHF 1.20 per euro. It scrapped the floor because defending it needed permanent interventions of rapidly increasing size. It also cut its deposit rate to -0.75% when it did so.[3]
In April 2025 Argentina ended exchange controls that had been in place since 2019. The peso was allowed to trade within a band of 1,000 to 1,400 pesos per dollar.[6] The band's upper limit then rose by 1% a month, and PIIE (the Peterson Institute for International Economics) later described a currency crisis in autumn 2025.[5]
Everything above is the topic page. The pieces below take it further. Each one trains a particular assessment objective rather than covering the topic again, and they are added over the year.
Figures and facts were checked against these sources on 2 November 2026. Worked numbers labelled "Illustrative figures" are invented for teaching.
The CC Economics revision platform drills exchange rate systems with calculation and evaluation practice, and the Inner Academy covers the topic in recorded lessons.
See the Economics platformThe Inner Academy