DP Economics SL 4.5 Exchange Rates

DP Economics SL 4.5 Exchange Rates - Full notes

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DP Economics SL | 4.5 Exchange Rates

DP ECONOMICS · UNIT 4: THE GLOBAL ECONOMY

4.5

Exchange Rates

Full notes for SL · IB-style

Contents

1	What an exchange rate is
2	Floating exchange rates: demand and supply of a currency
3	Causes of changes in exchange rates
4	Consequences of exchange rate changes
5	Fixed and managed exchange rates
6	Comparing exchange rate systems
7	Exchange rate calculations
8	Price of exports and imports
9	Floating exchange rates: demand and supply
10	Causes of exchange rate changes
11	Fixed exchange rates
12	Managed exchange rates
13	Devaluation and revaluation
14	Consequences of depreciation
15	Consequences of appreciation
16	Comparing fixed and floating systems
17	Mixed review: worked problems
18	Additional exam-style practice
19	Speculation and exchange rates
20	Purchasing power parity and exchange rates
21	Exchange rates and tourism
22	Common misconceptions and links
23	Exam-style question with markscheme
24	Check your understanding
25	Summary and topic map

These are full teaching notes. Read each section in order, try the Think about it question before you read on, and do every Quick check before moving to the next section.

Before you start

Rate yourself on each statement now, and again after you've worked through the notes. Shade R (not yet), A (getting there) or G (confident).

I can…	R	A	G
define an exchange rate and convert between currencies
explain the demand for and supply of a currency in a floating system
explain the causes of appreciation and depreciation
explain the effects of exchange rate changes on inflation, growth, employment and the current account
explain how fixed and managed exchange rates are maintained
evaluate floating and fixed exchange rate systems

This booklet covers the SL syllabus for 4.5. The HL-only calculation section is not included.

Guiding questions

Why does the value of the rupee or the dollar change every day? Who gains and who loses when a currency falls? Why do some countries fix their exchange rates?

How this topic is examined

Exchange rates are examined in every unit-4 paper. Paper 2 texts often report a currency appreciation or depreciation and ask you to draw the currency market diagram and explain the effects on exports, imports, inflation and growth.

Precise diagrams (the axes are the exchange rate and the quantity of the currency) and correct causal chains earn the marks.

Command term	What the examiner wants
Define	the precise meaning, ideally in the IB wording, in one or two sentences
Draw / Sketch	a fully labelled diagram with every axis, curve, equilibrium and change labelled
Explain	a causal chain linked to economic theory, usually supported by a diagram
Analyse	break a situation into its parts and trace the effects of each
Evaluate / Discuss	weigh up arguments, question assumptions and reach a justified conclusion using real-world examples

How to use these notes

Each section teaches one part of the syllabus in full. You'll see these boxes throughout; each has one job:

Box	What it's for
Think about it	a question to get you thinking before a section; the answer comes in the section
Key point	the one idea you must not forget
Common mistake	an error examiners see every year, and how to avoid it
In the real world	where the economics shows up outside the classroom
Try this	something quick you can do yourself to test the idea
Worked example	full solutions with IB-style marks (M1 method, A1 answer, R1 reasoning)
Quick check	short questions to test yourself at the end of each section

1 What an exchange rate is

An exchange rate is the price of one currency in terms of another.

Think about it

If $1 buys 83 rupees today and 90 rupees next year, has the rupee become stronger or weaker? Who would be pleased?

An exchange rate is the value of one currency expressed in terms of another, for example US$1 = ₹83 or €1 = US$1.08. It tells you how much foreign currency you get for one unit of your own.

When a currency's value rises in a floating system, it appreciates: one unit buys more foreign currency. When its value falls, it depreciates. In a fixed system, a deliberate government decision to raise the value is a revaluation, and to lower it is a devaluation.

WORKED EXAMPLE 1 Converting currencies

The exchange rate is US$1 = ₹83. (a) What is the rupee price of a $40 book? (b) What is the dollar price of a ₹8 300 phone case?

Solution

(a) 40 × 83 = ₹3 320A1

(b) 8 300 ÷ 83 = $100A1

Quick check

1. Define appreciation.

2. If €1 = $1.10 changes to €1 = $1.20, has the euro appreciated or depreciated?

Answers: 1. a rise in the value of a currency in a floating system 2. appreciated

2 Floating exchange rates: demand and supply of a currency

In a floating system, the market sets the price of a currency.

In a floating exchange rate system, the exchange rate is determined by the demand for and supply of the currency in the foreign exchange market, without government intervention.

The demand for a currency (say, the US dollar) comes from foreigners who need dollars to: buy US exports of goods and services; invest in the US (foreign direct investment, buying US shares and bonds, depositing money in US banks); and speculate that the dollar will rise. It also comes from central banks buying dollars as reserves.

The supply of a currency comes from US residents who sell dollars to obtain foreign currency in order to: buy imports; invest abroad; and speculate against the dollar.

The diagram has the exchange rate (the price of the currency in another currency) on the vertical axis and the quantity of the currency on the horizontal axis. Demand slopes down (a cheaper dollar makes US exports cheaper, so foreigners want more dollars); supply slopes up. The equilibrium exchange rate is where they meet.

Figure 1. An increase in demand for the dollar raises the exchange rate from ERe to ER1: the dollar appreciates.

Quick check

1. Name three sources of demand for a currency.

2. Who supplies a currency?

Answers: 1. foreign buyers of exports, foreign investors, speculators 2. residents buying imports, investing abroad or speculating

3 Causes of changes in exchange rates

Anything that shifts demand for or supply of a currency changes its value.

Changes in demand for exports and imports. If foreign demand for a country's exports rises (because of higher foreign incomes or better quality), demand for its currency rises, and it appreciates. If domestic demand for imports rises, supply of the currency rises, and it depreciates.

Relative interest rates. If a country's interest rates rise relative to others, foreign savers want to deposit money there to earn higher returns. This 'hot money' flow increases demand for the currency, causing appreciation. Lower relative interest rates cause depreciation.

Relative inflation rates. If a country's inflation is higher than its trading partners', its exports become less competitive and imports more attractive. Demand for the currency falls and supply rises, so it depreciates.

Foreign direct investment and portfolio investment. Inflows of investment raise demand for the currency.

Speculation. If traders expect a currency to rise, they buy it, which itself makes it rise. Speculation can cause large, sudden movements.

Central bank intervention. A central bank can buy or sell its own currency to influence its value (Section 5).

Remittances, aid and debt payments also affect flows of currency.

Change	Effect on currency
higher foreign demand for exports	appreciates
higher domestic demand for imports	depreciates
interest rates rise relative to others	appreciates
inflation higher than trading partners	depreciates
inflow of FDI	appreciates
speculators expect a fall	depreciates

Common mistake

Saying 'higher inflation makes the currency appreciate'. Higher relative inflation makes exports less competitive, reducing demand for the currency: it depreciates.

Quick check

1. How do higher interest rates affect a currency?

2. How does higher relative inflation affect a currency?

3. What is hot money?

Answers: 1. appreciation via inflows of savings 2. depreciation 3. short-term capital flows chasing higher interest returns

4 Consequences of exchange rate changes

A falling currency helps exporters but raises import prices.

Consider a depreciation. Exports become cheaper in foreign currency, so foreign demand for them rises; imports become dearer in domestic currency, so domestic demand for them falls. The effects are:

Current account. Export revenue may rise and import spending fall, improving the current account, though the effect depends on price elasticities and takes time (see the J-curve at HL, 4.6).

Economic growth and employment. Higher net exports raise AD, increasing output and employment in export and import-competing industries.

Inflation. Dearer imports, especially of energy, food and components, raise costs and the price level (cost-push inflation). Higher AD may add demand-pull pressure.

Living standards. Consumers pay more for imported goods and foreign travel.

An appreciation has the opposite effects: cheaper imports help consumers and reduce inflation, but exporters lose competitiveness, the current account may worsen and jobs may be lost.

	Depreciation	Appreciation
Export prices (in foreign currency)	fall	rise
Import prices (in domestic currency)	rise	fall
Current account	may improve	may worsen
AD and growth	may rise	may fall
Inflation	rises	falls
Consumers	lose (dearer imports)	gain (cheaper imports)

In the real world

In 2022 the US dollar appreciated strongly as US interest rates rose. Countries whose currencies depreciated against the dollar, such as Japan and the UK, faced higher import prices for oil and food, adding to inflation.

Quick check

1. How does a depreciation affect inflation?

2. Why might a depreciation increase employment?

Answers: 1. imports dearer, raising costs and prices 2. exports rise, raising AD and output

5 Fixed and managed exchange rates

Some governments decide what their currency is worth.

In a fixed exchange rate system, the government or central bank sets the value of the currency against another currency (often the US dollar) or a basket, and maintains it by intervening in the market. Hong Kong has pegged its dollar to the US dollar since 1983; several Gulf states also peg to the dollar.

To keep the currency from falling, the central bank buys its own currency using foreign currency reserves (raising demand), or raises interest rates to attract inflows. It may also restrict imports or capital outflows. To keep it from rising, it sells its own currency (increasing supply) and builds up foreign reserves, or lowers interest rates.

A managed float lies in between: the currency floats, but the central bank intervenes from time to time to limit large or rapid movements. Many countries, including India and China, operate some form of managed exchange rate.

Figure 2. To stop an appreciation in a fixed system, the central bank sells its own currency, increasing supply until the rate returns to the target.

Quick check

1. How does a central bank stop its fixed currency from falling?

2. What is a managed float?

Answers: 1. buys its own currency with reserves / raises interest rates 2. a floating rate with occasional central bank intervention

6 Comparing exchange rate systems

Flexibility versus certainty.

	Floating	Fixed
Advantages	automatic adjustment of the current account; monetary policy free to target domestic goals; no need for large reserves	certainty for traders and investors; discipline on inflation; less speculation if credible
Disadvantages	uncertainty and volatility; speculative swings; may worsen inflation when the currency falls	requires large reserves; monetary policy tied to the peg; risk of speculative attack; misalignment if set at the wrong level

No system is best for every country. Small, very open economies or those with a history of high inflation may benefit from the credibility of a fixed rate. Large economies with independent central banks usually prefer floating rates so that they can use monetary policy for domestic goals.

In the real world

In 1992 the UK was forced out of the European Exchange Rate Mechanism when speculators sold pounds heavily, betting that the Bank of England could not hold the pound's value. Despite raising interest rates and spending billions of reserves, the government had to let the pound fall.

7 Exchange rate calculations

Converting currencies.

An exchange rate is the price of one currency in terms of another. If £1 = $1.25, then $1 = £1/1.25 = £0.80. To convert, multiply or divide by the rate as appropriate.

WORKED EXAMPLE 2 Conversion (standard)

£1 = $1.25. (a) Convert £400 to dollars. (b) Convert $500 to pounds.

Solution

(a) 400 × 1.25 = $500A1

(b) 500/1.25 = £400A1

Quick check

1. If €1 = ¥160, convert ¥8000 to euros.

2. If £1 = $1.25 changes to £1 = $1.40, has the pound appreciated?

Answers: 1. 8000/160 = €50 2. yes

8 Price of exports and imports

Effects of exchange rate changes.

When a currency appreciates, exports become more expensive abroad and imports cheaper at home. When it depreciates, exports become cheaper abroad and imports more expensive.

WORKED EXAMPLE 3 Export price (exam level)

A UK car costs £20 000. Calculate its price in dollars at £1 = $1.25 and at £1 = $1.40.

Solution

$25 000 and $28 000A1 A1

Appreciation makes UK exports dearer in the USR1

9 Floating exchange rates: demand and supply

Market determination.

In a floating system, the exchange rate is determined by demand for and supply of the currency. Demand comes from foreigners buying exports, investing in the country, and speculators; supply comes from residents buying imports and investing abroad.

Figure 3. The exchange rate is set where demand for the currency equals supply.

WORKED EXAMPLE 4 Demand (standard)

State three sources of demand for a currency.

Solution

Foreign demand for exports; inward investment (FDI, portfolio)A1

Speculation; tourism by foreignersA1

10 Causes of exchange rate changes

Shifts in demand and supply.

Change	Effect on currency
higher domestic interest rates	demand rises: appreciation
higher domestic inflation	exports less competitive: depreciation
rising foreign incomes	more exports: appreciation
inward FDI	appreciation
speculation of future rise	appreciation
central bank sells currency	depreciation

WORKED EXAMPLE 5 Interest rates (exam level)

Explain the effect of a rise in interest rates on the exchange rate.

Solution

Higher returns attract foreign financial investmentR1

Demand for currency rises: appreciationR1

11 Fixed exchange rates

Government sets the value.

Under a fixed exchange rate, the government or central bank maintains the currency at a set value by buying or selling foreign reserves and adjusting interest rates. Examples: Hong Kong dollar pegged to the US dollar; Gulf states.

WORKED EXAMPLE 6 Maintaining a peg (exam level)

Explain how a central bank prevents its currency falling below the peg.

Solution

Buys its own currency using foreign reservesR1

Raises interest rates to attract inflowsR1

12 Managed exchange rates

A middle way.

Under a managed float, the exchange rate is mainly determined by the market, but the central bank intervenes to limit volatility or keep the rate within a range.

Quick check

1. Give one advantage of a managed exchange rate.

Answers: 1. allows market determination while limiting volatility

13 Devaluation and revaluation

Changes under fixed rates.

Under a fixed system, a government may devalue (lower the fixed rate) to improve competitiveness or revalue (raise it). Under floating rates the terms are depreciation and appreciation.

Quick check

1. Distinguish devaluation from depreciation.

Answers: 1. devaluation: deliberate reduction of a fixed rate; depreciation: market-driven fall

14 Consequences of depreciation

Winners and losers.

Depreciation makes exports more competitive and may raise AD and employment; it raises import prices, causing cost-push inflation and lowering living standards; it increases the burden of foreign-currency debt.

WORKED EXAMPLE 7 Inflation (exam level)

Explain how a depreciation can cause inflation.

Solution

Imported goods and raw materials cost moreR1

Higher costs and AD from exports raise the price levelR1

15 Consequences of appreciation

Strong currency effects.

Appreciation lowers import prices (reducing inflation) and benefits consumers and importing firms, but harms exporters and import-competing industries, possibly increasing unemployment.

Quick check

1. Why might an appreciation reduce inflation?

Answers: 1. cheaper imports and lower costs of imported inputs

16 Comparing fixed and floating systems

Pros and cons.

Feature	Floating	Fixed
certainty for trade	low	high
automatic adjustment of deficits	yes	no
independent monetary policy	yes	limited
need for reserves	low	high
speculative attacks	less likely	possible

17 Mixed review: worked problems

Bringing the ideas together.

WORKED EXAMPLE 8 Mixed problem (exam level)

$1 = ₹83 changes to $1 = ₹88. (a) Has the rupee appreciated or depreciated? (b) An Indian export costs ₹8800. Calculate its dollar price before and after.

Solution

(a) depreciated (more rupees per dollar)A1

(b) $106.02 before; $100 afterA1 A1

18 Additional exam-style practice

Paper 1 and Paper 3.

WORKED EXAMPLE 9 Paper 1 part (b) (exam level)

Evaluate the effects of a depreciation of a country's currency. [15]

Solution

Diagram showing depreciation; export competitiveness, ADR1 R1

Inflation, debt burden, living standardsR1

Elasticities, J-curve, time frame; judgementR1 R1

19 Speculation and exchange rates

Expectations matter.

Large flows of 'hot money' move between currencies seeking higher returns or expected appreciation, causing volatility. Speculative attacks can force countries to abandon fixed exchange rates.

In the real world

In 1992 speculators sold pounds heavily, forcing the UK to leave the European Exchange Rate Mechanism on 'Black Wednesday'.

Quick check

1. How can speculation cause a currency to fall?

Answers: 1. mass selling in expectation of a fall increases supply, causing the fall

20 Purchasing power parity and exchange rates

Long-run benchmark.

PPP theory suggests that in the long run exchange rates adjust so that a basket of goods costs the same in each country. The Big Mac index is a light-hearted test of PPP.

WORKED EXAMPLE 10 Big Mac (standard)

A Big Mac costs $5.50 in the US and ¥480 in Japan. Calculate the implied PPP exchange rate.

Solution

480/5.50M1

≈ ¥87 per $A1

21 Exchange rates and tourism

Travel effects.

A depreciation makes a country cheaper for foreign tourists, increasing tourism exports, while making travel abroad more expensive for residents.

Quick check

1. How does a weaker currency affect inbound tourism?

Answers: 1. increases it: the country becomes cheaper for visitors

22 Common misconceptions and links

Students often think…	Actually…
a depreciation always improves the current account	it depends on elasticities and takes time
higher inflation strengthens a currency	it weakens it
revaluation and appreciation are the same	revaluation is a deliberate change in a fixed system
a strong currency is always good	it helps consumers but hurts exporters

How 4.5 connects to the rest of the course

Topic	Connection
4.6 Balance of payments	exchange rates and the current account
3.6 Monetary policy	interest rates and the currency
4.4 Monetary union	a single currency removes exchange rates
3.3 Inflation	imported inflation

23 Exam-style question with markscheme

Try this under exam conditions (about 18 minutes) before reading the markscheme.

Figure 4. The yen–dollar exchange rate.

Text A. The Bank of Japan kept interest rates near zero while the US Federal Reserve raised rates sharply. Japan also faced a rising bill for imported energy. The yen fell to its lowest level against the dollar in over 30 years.

(a) Calculate the percentage change in the value of the yen against the dollar between 2021 and 2023 (using ¥ per $). [2]

(b) Explain two reasons why the yen depreciated. [4]

(d) Explain one benefit and one cost of the depreciation for Japan. [4]

Markscheme

Part	Answer	Marks
(a)	value of ¥1 fell from 1/110 to 1/150 dollars	M1
	≈ −26.7%	A1
(b)	US interest rates rose relative to Japan's	R1
	capital flowed to the US (hot money)	R1
	higher energy import bill increased supply of yen	R1
	explanation	R1
(c)	diagram: supply of yen shifts right / demand shifts left	A1
	exchange rate falls	R1
	linked to interest differential	R1
	labels correct	R1
(d)	benefit: exports cheaper, tourism rises	R1 A1
	cost: imported inflation, dearer energy	R1 A1

Examiner's comments. In (a), many candidates calculated the dollar's appreciation (+36%) instead of the yen's depreciation. In (c), the axes must be the exchange rate and the quantity of yen.

24 Check your understanding

Section A: multiple choice

1. A depreciation of a currency means

A. it buys less foreign currency B. it buys more foreign currency C. its value is fixed D. interest rates rise

2. A rise in a country's interest rates relative to others is likely to

A. depreciate its currency B. have no effect C. appreciate its currency D. reduce exports

3. Demand for a currency comes from

A. residents buying imports B. foreigners buying the country's exports C. residents investing abroad D. residents travelling abroad

4. Higher relative inflation tends to

A. appreciate the currency B. fix the currency C. raise exports D. depreciate the currency

5. A depreciation is likely to

A. lower import prices B. raise import prices C. reduce exports D. reduce inflation

6. To prevent a fixed currency from falling, the central bank

A. buys its own currency B. sells its own currency C. lowers interest rates D. prints money

7. A deliberate reduction in a fixed exchange rate is

A. a depreciation B. an appreciation C. a revaluation D. a devaluation

8. An advantage of a floating exchange rate is

A. certainty for traders B. no volatility C. monetary policy can target domestic goals D. no need for a central bank

Section B: structured

9. Using a diagram, explain how an increase in interest rates affects a floating currency. [4]

10. Explain the effects of a depreciation on the current account and inflation. [4]

11. Evaluate fixed exchange rates. [8]

Answers

1. A 2. C 3. B 4. D 5. B 6. A 7. D 8. C

9. Higher rates attract hot money; demand for currency shifts right; appreciation; diagram.

10. Exports cheaper, imports dearer, current account may improve (elasticities, time); imported inflation.

11. Certainty, discipline vs reserves, loss of monetary policy, speculative attack, misalignment; judgement.

25 Summary and topic map

Idea	Remember
Exchange rate	price of one currency in another
Appreciation / depreciation	rise / fall in a floating rate
Demand for currency	exports, inward investment, speculation
Supply of currency	imports, outward investment, speculation
Causes	interest rates, inflation, trade, investment, speculation
Depreciation effects	exports cheaper, imports dearer, AD up, inflation up
Fixed / managed	central bank buys or sells its currency; reserves; interest rates

Before the exam, make sure you…

•label axes: exchange rate and quantity of the currency
•shift the correct curve for each cause
•trace effects on exports, imports, AD and inflation
•compare floating and fixed systems

Exchange Rates on one page

Cover this page with a sheet of paper and try to rebuild it from memory. Whatever you can't recall is what to revise next.

Figure 5. Topic map for Exchange Rates.

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