Exchange rate systems (HL only)
IB Economics Higher LevelΒ· Unit 4: The Global EconomyΒ· 6 min read
1. Fixed Exchange Rate Systemsβ β βββHL onlyβ± 15 min
Fixed exchange rate system
A system where the central bank or government fixes the value of the domestic currency against a reference currency (e.g. the US dollar) or gold, and commits to maintaining this pegged value indefinitely.
Example:
The Hong Kong Dollar has been pegged to the US Dollar at a fixed rate since 1983.
To maintain the peg, the central bank must intervene in the foreign exchange market whenever the market exchange rate deviates from the official pegged rate. If supply of domestic currency exceeds demand at the pegged rate (downward pressure on the currency), the central bank buys excess domestic currency using its foreign exchange reserves. If demand exceeds supply (upward pressure), it sells domestic currency and adds to reserves.
The Bank of Thailand pegs the Thai Baht (THB) to the US Dollar at 1 USD = 25 THB. At this pegged rate, market supply of THB is 300 billion THB, while market demand is 220 billion THB. What action must the Bank of Thailand take to maintain the peg?
- 1
At the pegged rate, supply of THB exceeds demand by 80 billion THB. This creates downward pressure, which would push the exchange rate above 25 THB per USD (the Baht would depreciate) if no action is taken.
- 2
To eliminate the excess supply and maintain the peg, the Bank of Thailand buys the excess 80 billion THB using its US dollar foreign exchange reserves.
- 3
After intervention, total demand for THB increases by 80 billion to match supply, so the exchange rate stays at the official pegged level of 25 THB per USD.
Exam tip:
Always specify that intervention uses foreign exchange reserves to maintain a fixed peg. Generic statements about 'intervening' will not earn full marks in exams.
2. Floating Exchange Rate Systemsβ β βββHL onlyβ± 12 min
Floating exchange rate system
A system where the exchange rate is determined entirely by market forces of supply and demand, with no intervention from the central bank or government.
Example:
The US Dollar, Euro, and Japanese Yen operate as fully floating currencies.
In a pure floating system, any excess demand or supply is automatically adjusted through changes in the exchange rate. There is no need for the central bank to hold large foreign exchange reserves, and monetary policy remains fully independent to target domestic objectives like low inflation or full employment.
The Australian Dollar (AUD) is fully floating. Global demand for Australian iron ore exports increases sharply. How does the exchange rate adjust to this change?
- 1
Foreign buyers need AUD to pay for Australian iron ore exports, so demand for AUD increases in the foreign exchange market.
- 2
Supply of AUD remains unchanged, so excess demand pushes up the value of the AUD.
- 3
The exchange rate appreciates to a new equilibrium, with no central bank action required.
3. Managed Float Exchange Rate Systemsβ β β ββHL onlyβ± 18 min
Managed float (dirty float)
A hybrid exchange rate system where the exchange rate is mostly determined by market forces, but the central bank intervenes occasionally to prevent excessive volatility or currency misalignment, rather than defending a fixed target rate.
Example:
The Chinese Renminbi (CNY) operates under a managed float system.
The goal of intervention in a managed float is to smooth short-term fluctuations that could harm international trade and investment, rather than hitting a specific exchange rate target. Some managed systems allow the currency to fluctuate within a set band around a loose target, making them a middle ground between fully fixed and fully floating systems.
The Reserve Bank of India (RBI) manages the Indian Rupee (INR) under a managed float. A sudden global risk event causes a 5% one-week depreciation of the INR, driven by capital outflows. What action might RBI take?
- 1
A sudden sharp depreciation raises the cost of imported goods like oil, leading to domestic inflation and economic instability.
- 2
To slow the rapid depreciation, RBI sells US dollars from its foreign reserves and buys INR, increasing demand for INR to reduce the pace of decline.
- 3
RBI does not try to return the INR to its previous specific level. It only intervenes to reduce excessive short-term volatility.
4. Evaluation of Exchange Rate Systemsβ β β β βHL onlyβ± 20 min
IB Economics HL exams regularly require evaluation of which exchange rate system is most suitable for a given economy. Key evaluation criteria include monetary policy autonomy, exchange rate stability for trade, inflation credibility, and resilience to external economic shocks.
Exchange Rate System | Key Advantages | Key Disadvantages |
|---|---|---|
Fixed | Low volatility (promotes trade/investment), inflation control discipline | Requires large reserves, loss of monetary policy independence, currency crisis risk |
Floating | Full monetary policy autonomy, no reserve requirement, automatic shock adjustment | High volatility, discourages cross-border trade and investment |
Managed Float | Balances stability and flexibility, retains policy freedom | Risk of currency manipulation accusations, persistent uncertainty for traders |
Test your understanding of core advantages:
Which of the following is a key advantage of a fixed exchange rate system?
A. Full monetary policy independence
B. Reduced exchange rate risk for international traders
C. No need for foreign exchange reserves
D. Automatic adjustment to external shocks
Reveal answer
B βCorrect! Fixed exchange rates eliminate short-term volatility, which reduces risk for importers and exporters. The other options are all advantages of floating exchange rate systems.
5. Common Pitfalls
Wrong move:
Confusing devaluation (fixed system) with depreciation (floating system)
Why:
Devaluation is a deliberate policy action in a fixed system, while depreciation is a market-driven decline in currency value
Correct move:
Use 'devaluation'/'revaluation' only for fixed pegs, and 'depreciation'/'appreciation' for market-driven changes
Wrong move:
Claiming no intervention occurs in a managed float system
Why:
Managed floats rely on occasional intervention to reduce volatility; the difference from fixed is the lack of a fixed target
Correct move:
Acknowledge intervention happens in managed floats, but it targets volatility not a specific pegged rate
Wrong move:
Stating that fixed exchange rates are permanently fixed
Why:
Many fixed pegs are adjusted periodically via devaluation/revaluation to reflect changing economic conditions
Correct move:
Clarify that central banks commit to maintaining the current peg, but can change the peg level when needed
Wrong move:
Claiming floating exchange rates eliminate all balance of payments imbalances
Why:
While floating rates facilitate adjustment, persistent structural imbalances can still exist
Correct move:
Explain that floating rates make adjustment easier, but do not automatically eliminate persistent imbalances
6. Quick Reference Cheatsheet
System | Price Determination | Central Bank Intervention | Key Feature |
|---|---|---|---|
Fixed | Pegged to reference | Continuous to maintain peg | No independent monetary policy |
Floating | Market supply/demand | None | Full monetary policy autonomy |
Managed Float | Mostly market | Occasional to reduce volatility | Hybrid, balances stability and flexibility |
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.
- 2025 Β· 3
Evaluate managed vs floating systems
- 2023 Β· 3
Explain fixed rate central bank intervention
- 2021 Β· 3
Compare advantages of two systems
What's Next
Understanding exchange rate systems is a foundational HL topic that connects to all core themes of the global economy. Different systems have distinct implications for balance of payments adjustment, the effectiveness of fiscal and monetary policy, and economic integration through trade blocs. This topic is regularly examined in Paper 3 as part of longer evaluation questions, so it is critical to be able to compare systems with real-world examples. The knowledge you build here will support your learning of more advanced open-economy macroeconomic topics.