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O The demand curve for pounds is negatively sloped, and the supply
curve of pounds is positively sloped.
O The demand for pounds is D. It represents the sum of transactions
giving rise to receipts of foreign exchange. When the exchange rate is
e0 the quantity of pounds demanded is q0.
O A depreciation of the pound is indicated by a fall in the exchange rate to
e1; foreign demand for UK goods and assets rises, and hence the
quantity of pounds demanded also rises, from q0 to q1.
O An appreciation has the opposite effect; a rise in the exchange rate from
e1 to e0 causes the quantity of pounds demanded to fall from q1 to q0.
O The supply of pounds is given by line S. It represents the sum of
transactions that require payments of foreign exchange. When the
exchange rate is e0 the quantity of pounds supplied is q2.
O If the exchange rate falls to e1, UK demand for foreign goods and assets
falls, and hence the quantity of pounds supplied also falls, from q2 to q3.
O An appreciation has the opposite effect; a rise in the exchange rate from
e1 to e0 causes the quantity of pounds supplied to rise from q3 to q2.
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O Under a fixed exchange rate regime the authorities intervene in the

foreign exchange market to ensure that the exchange rate stays
within specified bands.
O The supply curve is S, and the exchange rate is pegged within the
range $1.50-£1.60. If the demand curve is given by D0 the
equilibrium exchange rate is within the bands so no intervention by
the authorities is required.
O With demand curve D1 the equilibrium exchange rate would be
above $1.60.
O To stop the exchange rate rising above $1.60, the authorities have to
sell q4q1 pounds per period and buy dollars of equivalent value. For
every £100 sold, they will acquire $160.
O If the demand curve were D2, the exchange rate would fall bellow
$1.50 in a free market, so the authorities have to buy q2q3 pounds
per period with dollars.
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O An increase in the demand for pounds or a decrease in the supply

will cause the pound to appreciate; a decrease in the demand or an
increase in supply will cause it to depreciate.
O The initial demand and supply curves, D0 and S0, are shown as solid
lines. Equilibrium is at E0 with an exchange rate of e0.
O An increase in the demand for pounds, as shown by a rightward shift
in the demand curve from D0 to D1 in part (i), or a decrease in the
supply of pounds, as shown by a leftward shift in the supply curve
from S to S in part (ii), will cause the pound to appreciate. In both
parts the new equilibrium is at E1, and the appreciation is shown by
the rise in the exchange rates from e0 to e1.
O A decrease in the demand for pounds, as shown by a leftward shift
in the demand curve from D1 to D0 in part (i), or an increase in the
supply of pounds, as shown by rightward shift in the supply curve
from S1 to S0 in part (ii), will cause the pound to depreciate. The
equilibrium will shift from E1 to E0, and the depreciation is shown by
the fall in the exchange rate from e1 to e0 in both parts.