Study Guide

Exchange rate determination

IB Economics HLΒ· IB Economics 2020 Syllabus, Topic 4.4Β· 15 min read

1. Key Definitions and Exchange Rate Systemsβ˜…β˜…β˜†β˜†β˜†β± 5 min

πŸ“˜ Definition

Exchange Rate

EE

The price of one currency expressed in terms of another currency, determined by supply and demand in the foreign exchange market

Example:

1 EUR = 1.08 USD means the exchange rate of EUR against USD is 1.08

There are three primary systems used globally to determine currency values, each with different levels of government intervention:

  • Floating (flexible) exchange rate: Currency value is set entirely by market supply and demand, with no regular government intervention

  • Fixed exchange rate: Currency value is officially pegged to another currency (e.g. USD) or gold, and the central bank intervenes constantly to maintain the peg

  • Managed exchange rate: A hybrid system where currency value is mostly market-determined, but central banks intervene occasionally to reduce excessive volatility

πŸ“ Worked Example

Classify each scenario as floating, fixed or managed exchange rate: (a) Bank of Japan buys USD to prevent the yen from appreciating too quickly. (b) The US dollar’s value changes daily based on global trading with no official peg.

  1. 1
    1. For scenario (a): The yen’s value is mostly set by market forces, but the central bank intervenes to limit extreme movement. This matches the definition of a managed exchange rate.
  2. 2
    1. For scenario (b): The US dollar’s value is determined entirely by market forces with no official peg or regular intervention, so it is classified as a floating exchange rate.

Exam tip:

Always label your foreign exchange diagram correctly: y-axis = exchange rate (price of domestic currency), x-axis = quantity of domestic currency.

2. Exchange Rate Changes under Floating Systemsβ˜…β˜…β˜…β˜†β˜†β± 6 min

πŸ“˜ Definition

Appreciation and Depreciation

Appreciation is an increase in the value of a domestic currency under a floating system, caused by an increase in demand or decrease in supply of the currency. Depreciation is a decrease in value caused by opposite shifts.

Example:

If 1 GBP rises from 1.20 USD to 1.25 USD, GBP has appreciated against USD.

Any factor that changes supply or demand for a currency will shift the relevant curve and change the equilibrium exchange rate. Common drivers of shifts include:

  • Higher relative interest rates increase foreign investment demand β†’ demand shifts right β†’ appreciation

  • Higher relative domestic inflation makes exports less competitive β†’ demand shifts left β†’ depreciation

  • Increased foreign demand for domestic exports increases demand for domestic currency β†’ appreciation

  • Domestic capital outflows increase supply of domestic currency β†’ supply shifts right β†’ depreciation

πŸ“ Worked Example

Australia raises its interest rate relative to the EU. Using foreign exchange market analysis, explain what happens to the value of the Australian dollar (AUD) against the euro (EUR).

  1. 1
    1. Higher relative interest rates in Australia make Australian assets (e.g. government bonds) more attractive to European investors. This increases demand for AUD from European investors.
  2. 2
    1. The demand curve for AUD shifts rightwards from to , while the supply curve of AUD remains unchanged in the short run.
  3. 3
    S=S1,D1β†’D2β€…β€ŠβŸΉβ€…β€ŠE2>E1S = S_1, D_1 \to D_2 \implies E_2 > E_1
  4. 4
    1. The new equilibrium exchange rate is higher than the original, meaning one AUD buys more EUR. Therefore, AUD appreciates against the EUR as a result of the interest rate rise.

3. Central Bank Intervention under Fixed Systemsβ˜…β˜…β˜…β˜…β˜†β± 6 min

Under a fixed exchange rate system, the central bank must intervene whenever the market equilibrium exchange rate deviates from the official pegged value. Intervention uses foreign currency reserves to adjust the supply of domestic currency in the foreign exchange market.

πŸ“˜ Definition

Devaluation vs Revaluation

If the peg becomes unsustainable, the central bank will make a deliberate policy adjustment: devaluation (lowering the pegged value) or revaluation (increasing the pegged value).

πŸ“ Worked Example

A country pegs its currency (the Peso) to the USD at 20 Pesos = 1 USD. Increased market demand for USD pushes the equilibrium rate to 22 Pesos = 1 USD. What action must the central bank take to maintain the peg?

  1. 1
    1. The market rate of 22 Pesos = 1 USD means the Peso is weaker than the official peg: 1 Peso = 0.05 USD at the peg, but only ~0.045 USD on the market. The peso is overvalued at the current peg.
  2. 2
    1. To increase the value of the Peso back to the peg, the central bank must increase demand for Peso by selling its USD foreign reserves and buying Pesos from the foreign exchange market.
  3. 3
    1. This intervention shifts the demand curve for Peso rightwards, returning the equilibrium exchange rate to the official peg of 20 Pesos = 1 USD.

Exam tip:

To maintain an overvalued fixed exchange rate, central banks sell foreign reserves and buy domestic currency. To maintain an undervalued rate, they sell domestic currency and buy foreign reserves.

4. Exchange Rate Calculations for Paper 3β˜…β˜…β˜…β˜†β˜†HL only⏱ 4 min

IB Economics HL Paper 3 regularly assesses your ability to calculate percentage changes in exchange rates. The standard percentage change formula applies:

Percentage Change=New Valueβˆ’Original ValueOriginal ValueΓ—100%\text{Percentage Change} = \frac{\text{New Value} - \text{Original Value}}{\text{Original Value}} \times 100\%
πŸ“ Worked Example

The GBP/USD exchange rate changes from 1 GBP = 1.20 USD to 1 GBP = 1.26 USD. Calculate the percentage change in the value of GBP, and state if it appreciated or depreciated.

  1. 1
    1. Original value of 1 GBP is 1.20 USD, new value is 1.26 USD.
  2. 2
    Percentage Change=1.26βˆ’1.201.20Γ—100%=5%\text{Percentage Change} = \frac{1.26 - 1.20}{1.20} \times 100\% = 5\%
  3. 3
    1. The change is positive, so the value of GBP increased against USD. GBP appreciated by 5%.

5. Common Pitfalls

Wrong move:

Confusing depreciation and devaluation

Why:

Both describe a fall in currency value, but they occur under different exchange rate systems

Correct move:

Depreciation is market-driven under floating rates; devaluation is a deliberate policy change under fixed rates

Wrong move:

Putting quantity of domestic currency on the y-axis of an FX diagram

Why:

Exchange rate is the price of domestic currency, so it belongs on the y-axis

Correct move:

Label y-axis = Exchange rate (price of domestic currency), x-axis = Quantity of domestic currency

Wrong move:

Calculating percentage change as (new - old)/new

Why:

Percentage change is always measured relative to the original value, not the new one

Correct move:

Use (new - original)/original Γ— 100% for all percentage change calculations

Wrong move:

Claiming central banks can maintain a fixed peg indefinitely

Why:

Central banks have a limited supply of foreign currency reserves to defend an overvalued peg

Correct move:

Acknowledge that persistent intervention can lead to reserve depletion and eventual devaluation

Wrong move:

Claiming appreciation always reduces net exports

Why:

The impact of exchange rate changes on net exports depends on export/import elasticities

Correct move:

Reference the Marshall-Lerner condition when evaluating the effect of exchange rate changes on net exports

6. Quick Reference Cheatsheet

Concept

Exchange Rate System

Core Definition

Appreciation

Floating

Market-driven increase in currency value

Depreciation

Floating

Market-driven decrease in currency value

Devaluation

Fixed

Deliberate downward policy adjustment of peg

Revaluation

Fixed

Deliberate upward policy adjustment of peg

Floating

All

Entirely market-determined, no regular intervention

Fixed

All

Officially pegged, constant central bank intervention

Managed

All

Mostly market-driven, occasional intervention

7. Frequently Asked

What is the difference between depreciation and devaluation?

Depreciation is a fall in currency value caused by market forces under a floating exchange rate system. Devaluation is a deliberate policy decision to lower the value of a currency under a fixed exchange rate system.

When this came up on past exams

AI-estimated based on syllabus patterns β€” cross-check with official past papers for accuracy. Use only as revision-focus signals.

  • 2023 Β· 1

    10-mark exchange rate fluctuation explanation

  • 2022 Β· 3

    Exchange rate calculation problem

  • 2021 Β· 2

    Evaluate fixed vs floating systems

Going deeper

What's Next

Understanding exchange rate determination is the foundation for analyzing the effects of exchange rate changes, currency crises, and government intervention in the foreign exchange market, all core, heavily tested topics for IB Economics HL. This concept is also closely linked to balance of payments adjustment and macroeconomic policy in open economies, which feature regularly in 15-mark evaluation questions on Papers 1 and 2. Mastering the core concepts in this sub-topic will prepare you to answer higher-mark questions comparing the merits of different exchange rate systems.