The floating exchange rate diagram: demand for pounds from exports and capital inflows, supply from imports and capital outflows, what makes the pound appreciate or depreciate, strong pound imports cheap exports dear, managed floats and the effect on AD and inflation.
On 5 February 2026 the Bank of England kept Bank Rate at 3.75%. The vote was much closer than expected: five members of the Monetary Policy Committee voted to hold and four voted to cut to 3.5%.
Traders took the close vote as a sign that a cut was coming soon. That afternoon the pound fell 0.6% against the dollar, to about $1.357.
Interest rates did not change that day. So why did the price of the pound fall?
Sources: Bank of England, Monetary Policy Summary and minutes, February 2026 (published 5 February 2026); Reuters, Bank of England leaves rates unchanged, sterling falls (5 February 2026).
An exchange rate is the price of one currency in terms of another, such as £1 = $1.25. Pounds are bought and sold on the foreign exchange market, so the pound has a price like any other good.
Under a free float the exchange rate is set only by the demand for and supply of the currency. The central bank does not step in. A rise in the price of the pound is an appreciation (a stronger pound); a fall is a depreciation (a weaker pound).
The model assumes two currencies, the pound and the dollar, and that only one cause changes at a time (ceteris paribus). The UK pound has floated since September 1992.
The Bank of England raises interest rates. US interest rates stay the same.
Before the rise, £1 buys $1.25.
What is most likely to happen to the price of the pound in dollars?
Higher UK interest rates make saving in pounds more rewarding, so money flows in from abroad. To save in the UK, foreign savers must buy pounds. Demand for pounds rises and the pound appreciates. This lesson shows why on the diagram.
Axes first: the price of £ in $ up the side, the quantity of pounds along the bottom. Then the demand for pounds, D1. It comes from people abroad who need pounds: buyers of UK exports and capital inflows, such as foreign firms building factories here and savers putting money in UK banks. It slopes down: the cheaper the pound, the cheaper UK goods are in dollars, so more pounds are wanted.
Teacher tip: Label the vertical axis as the price of the pound in another currency, not just price. An unlabelled axis is the most common slip on this diagram.
Check: Which of these people demand pounds on the foreign exchange market?
The American firm has dollars and must pay in pounds, so it buys pounds. Demand for pounds comes from people abroad buying UK exports or investing in the UK.
Now the supply of pounds, S1. It comes from people in the UK who sell pounds to get dollars: buyers of imports and capital outflows, such as UK firms investing in the US and UK savers buying foreign shares. It slopes up: the more dollars each pound buys, the cheaper US goods are in pounds, so more pounds are sold to buy them.
Teacher tip: Ask who is changing money, and which way. Buying pounds is demand. Selling pounds is supply.
Where D1 meets S1 is the equilibrium exchange rate: £1 = $1.25, P1, with Q1 pounds traded. Read it across to both axes and label P1 and Q1, just as in any market diagram.
Check: The price of the pound is $1.40, above where D1 and S1 cross. What happens next?
At $1.40 more pounds are offered for sale than are wanted, so sellers accept fewer dollars per pound until the market clears at P1.
Now the Bank of England raises interest rates while US rates stay the same. Predict before the next step: which curve moves?
Check: The Bank of England raises Bank Rate and US rates stay the same. What happens on the diagram?
Saving in pounds now earns more, so savers abroad buy pounds to put in UK accounts. More pounds are wanted at every price, so demand shifts right.
Higher UK rates attract **hot money**: savings that move between countries to earn the best return. To save in pounds, savers abroad must buy pounds, so demand shifts right to D2. At $1.25 there is now excess demand, so the price is bid up to P2, $1.35. The pound has appreciated.
Teacher tip: Show the shift with an arrow and label the new curve D2. Then read P2 across: it must be above P1.
The causes to know for the exam: interest rates (hot money), inflation compared with other countries, speculation about where the pound is heading and trade flows, such as stronger demand for UK exports. Inward investment, such as a foreign carmaker building a UK plant, also raises demand for pounds.
Check: Prices in the UK rise more slowly than in the US. What happens to the pound?
UK goods become relatively cheaper, so foreigners buy more UK exports (demand for pounds rises) and UK buyers buy fewer imports (supply of pounds falls). Both push the pound up.
Back to D1 and S1 at $1.25. Now the opposite case. Predict first: UK households buy more imported goods from the US.
Check: UK households buy more goods made in the US. Which curve shifts, and which way?
To pay for US goods, UK buyers must sell pounds for dollars. More pounds are offered at every price, so supply shifts right.
To pay for the imports, UK buyers sell more pounds, so supply shifts right to S2. At $1.25 there is excess supply of pounds, so the price falls to $1.15. The pound has depreciated. A cut in UK interest rates, higher UK inflation than abroad or traders expecting the pound to fall all work the same way: more pounds sold, a weaker pound.
Back to February 2026. The rate did not change, but four of the nine members wanted a cut. Traders expected lower UK rates soon, so they sold pounds straight away.
Check: Bank Rate was not cut on 5 February 2026, yet the pound fell. What is the best explanation?
The close vote made a cut look likely, so traders sold pounds ahead of it. That is speculation: the supply of pounds rose on expectations alone.
The papers often ask for the percentage change in an exchange rate. Percentage change = (new − old) ÷ old × 100. For the rise from $1.25 to $1.35: 0.10 ÷ 1.25 × 100 = 8%. The pound appreciated by 8% against the dollar.
Teacher tip: Always divide by the old rate. Dividing by the new rate is the slip that costs the calculation mark.
Check: The pound falls from $1.25 to $1.15. What is the percentage change in the exchange rate?
(1.15 − 1.25) ÷ 1.25 × 100 = −0.10 ÷ 1.25 × 100 = −8%.
What does a stronger pound do? Remember **SPICED**: strong pound, imports cheap, exports dear. A UK car priced at £30,000 costs an American $37,500 at $1.25 (30,000 × 1.25) but $40,500 at $1.35. So UK exports are dearer abroad. A weak pound does the reverse: imports dear, exports cheap.
Teacher tip: SPICED alone is not an explanation. Show the conversion: multiply pounds by the rate to get dollars, divide dollars by the rate to get pounds.
Check: The pound rises from $1.25 to $1.35. A US laptop costs $1,350. What happens to its price in pounds?
$1,350 ÷ 1.25 = £1,080; $1,350 ÷ 1.35 = £1,000. Each pound buys more dollars, so imports cost fewer pounds.
The link to the whole economy. An appreciation cuts exports and raises imports, so net exports (X − M) fall and AD shifts left, from AD1 to AD2. Real GDP falls from Y1 to Y2 and the price level is lower. Cheaper imported fuel and materials also cut firms’ costs, which eases inflation further.
Check: The pound appreciates. What is the most likely effect on UK aggregate demand?
Exports are dearer abroad, so fewer are sold; imports are cheaper, so more are bought. X − M falls, so AD shifts left.
In a **managed float** the currency floats, but the central bank steps in to steer it. Here demand falls to D2. Left alone, the pound would fall to P2, $1.15. To hold it at $1.25, there is an excess supply of £20bn (70 − 50) that someone must buy.
Check: Demand for pounds falls, but the Bank of England wants to keep £1 = $1.25. What could it do?
Buying pounds adds to demand for pounds, which holds the price up.
The Bank can buy pounds with its reserves of foreign currency, adding £20bn of demand, or raise interest rates to pull hot money in, which shifts demand back towards D1. Either way, the pound is held above its free-market level.
Holding a currency down is the mirror image. Demand rises to D2, so at $1.25 there is excess demand for pounds of £20bn (90 − 70). The bank sells its own currency or cuts interest rates. From 2011 to January 2015 the Swiss central bank sold francs to stop one euro buying fewer than 1.20 francs, to protect Swiss exporters.
Check: Why is it easier for a central bank to hold its currency down than to hold it up?
To hold a currency down, the bank sells its own currency, which it can create. To hold it up, it must spend foreign reserves, which run out.
They shifted demand for pounds to the left, so their pound depreciates. Higher UK interest rates attract hot money, so savers abroad buy more pounds: demand shifts right and the pound appreciates.
Explain, using a diagram, how a rise in UK interest rates is likely to affect the exchange rate of the pound.
An exchange rate is the price of one currency in terms of another. In a free float, the price of the pound in dollars is set by the demand for pounds, from exports and capital inflows, and the supply of pounds, from imports and capital outflows.
[Diagram: price of £ in $ against quantity of pounds. D1 and S1 crossing at P1 and Q1. D2 to the right of D1. New equilibrium at P2 and Q2, with P2 above P1 labelled as an appreciation.]
If the Bank of England raises interest rates while rates abroad stay the same, saving in the UK earns a higher return. Hot money flows into UK banks, and to save in pounds, savers abroad must buy pounds. Demand for pounds shifts right from D1 to D2. At the old rate P1 there is excess demand for pounds, so the price of the pound is bid up to P2. The pound appreciates.
However, the effect depends on what happens abroad: if US rates rise by the same amount, there is no extra reason to save in pounds. Hot money can also leave as quickly as it came, and in February 2026 the pound fell on the expectation of a cut before any cut happened. So expectations about future rates can matter as much as the rate itself.
Bank Rate decision: Bank of England, Monetary Policy Summary, February 2026. Sterling move: Reuters, 5 February 2026. The currency market figures in the diagram are invented to make the arithmetic clear. Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed.