Exchange Rates: IB Economics 4.5 notes

What an exchange rate is

An exchange rate is the price of one currency expressed in terms of another, for example 1 pound = 1.25 US dollars. Because it is a price, it is determined in a market (the foreign exchange market) by the demand for and supply of the currency.

Demand for a currency comes from foreigners wanting to buy that country's exports, invest in it, or hold its assets. Supply of a currency comes from domestic residents wanting foreign currency to buy imports or invest abroad. Where demand meets supply sets the equilibrium exchange rate.

Floating exchange rate determination

Under a floating system the rate is set purely by market supply and demand, with no central-bank target. On the currency-market diagram the vertical axis is the price of the domestic currency (in foreign currency) and the horizontal axis is the quantity of the domestic currency; demand slopes down and supply slopes up, and their intersection is the exchange rate.

Anything that shifts demand or supply moves the rate. Higher demand for exports, higher domestic interest rates attracting financial inflows, or expectations that the currency will rise all shift demand right and raise the rate. Higher demand for imports or capital outflows shift supply right and lower the rate.

Appreciation and depreciation: causes

An appreciation is a rise in a floating currency's value; a depreciation is a fall. Causes include changes in relative interest rates (a rate rise by a central bank such as the US Federal Reserve or the European Central Bank attracts financial inflows and tends to appreciate the currency), changes in relative inflation, changes in the demand for exports and imports, foreign direct investment flows, speculation, and remittances.

For example, if UK interest rates rise relative to the euro area, investors buy pounds to earn the higher return, demand for the pound shifts right, and the pound appreciates against the euro.

Consequences of a change in the exchange rate

A depreciation makes exports cheaper abroad and imports dearer at home, so it tends to raise net exports and boost aggregate demand and employment, but it also raises the price of imported goods and inputs, adding to inflation (imported inflation). An appreciation does the reverse: it lowers export competitiveness but reduces imported inflation and raises consumers' purchasing power over foreign goods.

A useful memory aid is WIDEC: with a Weaker currency, Imports are Dearer and Exports are Cheaper. For an appreciation the effects reverse: a stronger currency makes exports dearer and imports cheaper. Whether a depreciation actually improves the trade balance depends on elasticities (see the HL extension).

Fixed and managed systems, devaluation vs depreciation

Under a fixed exchange rate a central bank pegs the currency to another currency or basket and defends the peg by buying or selling foreign-exchange reserves and adjusting interest rates. Under a managed (dirty) float the rate mostly floats but the central bank intervenes occasionally to smooth or steer it. Most large economies today run managed floats.

Terminology matters in the exam: a fall in a fixed currency's official peg is a devaluation, and a rise is a revaluation, both deliberate policy decisions. A fall or rise of a floating currency driven by the market is a depreciation or an appreciation. Do not use 'devaluation' for a floating currency's market fall.

Overvalued and undervalued currencies

A currency is overvalued when its rate is held above the level a free market would set, and undervalued when held below it. A pegged currency can drift away from its market equilibrium, requiring intervention to hold the peg.

An undervalued currency keeps exports artificially cheap and supports export-led growth, but imports foreign inflation and can provoke accusations of currency manipulation from trading partners. An overvalued currency makes imports cheap but hurts export competitiveness and can drain reserves as the central bank defends the peg. Argentina's repeated struggles to hold an overvalued peg against high inflation, ending in forced devaluations, are a standard real-world example.

Exchange rate calculations (HL)

You must convert between currencies and compute percentage changes. If 1 pound = 1.25 dollars, then a good priced at 1.25 dollars costs 1 pound, and 100 dollars converts to 100 / 1.25 = 80 pounds. From the dollar's side, 1 dollar = 1 / 1.25 = 0.80 pounds.

For percentage change: if the pound moves from 1.25 to 1.40 dollars, the appreciation is (1.40 - 1.25) / 1.25 = 0.12, a 12 percent appreciation. Watch the direction of the quote: from the dollar's perspective the same move is 0.80 to about 0.714 pounds per dollar, a fall of about 10.7 percent, a depreciation of the dollar. The two percentages differ because the base differs, a classic HL trap.

How this is examined

• Draw the currency-market diagram with the correct axes: price of the domestic currency (in foreign currency) on the vertical axis, quantity of the domestic currency on the horizontal; label the shifting curve and the new equilibrium.
• Use the exact IB vocabulary: appreciation/depreciation for a floating (market) move, revaluation/devaluation for a deliberate change of a fixed peg. Mixing them costs marks.
• On HL numeric questions state which currency's percentage change you are giving; the reciprocal quote gives a different figure because the base changes.
• For evaluation, remember a depreciation's effect on the trade balance depends on elasticities (Marshall-Lerner) and shows a J-curve lag, so avoid claiming it 'automatically' improves the current account.

Key terms

exchange ratefloating exchange ratefixed exchange ratecurrency appreciationcurrency depreciation