Exchange Rates
IB Economics SLΒ· 4.4 Exchange ratesΒ· 45 min read
1. Exchange Rates in Floating Regimesβ β ββββ± 15 min
Exchange rate
The price of one national currency expressed in terms of another national currency, determined by market forces under a freely floating regime.
Demand for a domestic currency comes from foreign buyers who need to pay for domestic exports, services, or assets. Supply of the domestic currency comes from domestic buyers who need to exchange it for foreign currency to pay for imports, foreign services, or foreign assets. Equilibrium exchange rate occurs where quantity demanded equals quantity supplied.
The EU increases its imports of US manufactured electric vehicles. Using supply and demand analysis for the US dollar (USD) against the euro (EUR), explain how this affects the value of the USD.
- 1
- Higher EU demand for US exports means European importers need more USD to pay for the vehicles, so demand for USD increases.
- 2
- The demand curve for USD shifts right, while supply of USD remains unchanged in the short run.
- 3
- 4
- The equilibrium value of 1 USD in EUR increases, meaning the USD has appreciated against the EUR.
Exam tip:
Always specify which currency is changing value against which other currency β you will lose marks for vague statements like "the currency went up".
2. Terminology for Currency Value Changesβ β β βββ± 18 min
Currency value change terminology
Terms for currency value changes depend entirely on whether the regime is floating or fixed.
Example:
Market-driven changes use appreciation/depreciation; official changes use revaluation/devaluation.
Under a fixed exchange rate regime, the central bank sets a fixed value for the domestic currency against an anchor currency (usually the USD) or basket of currencies, and intervenes in foreign exchange markets to maintain this peg. Any change in the peg is an official policy decision, not a market outcome.
India pegs the rupee (INR) to the USD at an original rate of 1 USD = 75 INR. The Reserve Bank of India devalues the rupee to a new rate of 1 USD = 78 INR. Calculate the change in the value of 1 INR in USD and confirm the effect on export competitiveness.
- 1
- Original value of 1 INR in USD:
- 2
- 3
- New value of 1 INR after devaluation:
- 4
- 5
- 1 INR now buys less USD, so the rupee is cheaper for foreign buyers. This makes Indian exports cheaper for US buyers, improving India's export competitiveness, which is the typical goal of devaluation.
Which term describes a market-driven decrease in the value of a currency under a floating regime?
Devaluation
Depreciation
Revaluation
Appreciation
Reveal answer
1 βDevaluation is the term for an official policy-driven decrease under a fixed regime, while depreciation describes a market-driven decrease under a floating regime.
3. Comparison of Fixed and Floating Regimesβ β β βββ± 20 min
The two main regimes have distinct trade-offs for macroeconomic policy and economic performance:
Floating exchange rate
Value determined entirely (or mostly) by market forces
+ Pros: Automatic adjustment to external economic shocks; Full central bank autonomy for domestic monetary policy; No need to hold large foreign currency reserves
β Cons: High short-term exchange rate volatility; Volatility can discourage international trade and cross-border investment
Fixed exchange rate
Value set and maintained by the central bank
+ Pros: Reduced exchange rate uncertainty for trade/investment; Acts as a nominal anchor to control domestic inflation; Stabilizes commodity prices for small open economies
β Cons: Loss of autonomy for domestic monetary policy; Requires large foreign reserves to defend the peg; Vulnerable to speculative currency attacks
A small open economy with a fixed exchange rate wants to use expansionary monetary policy to escape a recession. Explain why this policy will usually fail.
- 1
- Expansionary monetary policy lowers domestic interest rates to encourage borrowing and spending.
- 2
- Lower domestic interest rates cause investors to move capital to foreign countries with higher returns, so supply of the domestic currency increases as investors sell it to buy foreign currency.
- 3
- To maintain the fixed peg, the central bank must buy all excess supply of domestic currency, paying for it with its foreign exchange reserves. This reduces the domestic money supply, pushing interest rates back up to their original level.
- 4
- The expansionary effect of the policy is completely offset, so output does not increase.
Exam tip:
The loss of monetary policy autonomy under fixed regimes is the most commonly tested evaluation point, so always include it in any comparison.
4. Common Pitfalls
Wrong move:
Mixing up terminology: calling a market-driven value change revaluation or devaluation
Why:
IB examiners explicitly test knowledge of correct terminology matching the regime, and marks are deducted for incorrect terms
Correct move:
Use appreciation/depreciation for market-driven changes under floating regimes, and revaluation/devaluation for official policy changes under fixed regimes
Wrong move:
Misreading exchange rate direction: if 1 GBP goes from $1.20 to $1.30, concluding GBP depreciated
Why:
Exchange rates are usually quoted as the value of 1 unit of the domestic currency in foreign currency, so an increase means the currency is more valuable
Correct move:
Always check the quote: an increase in GBP/USD (1 GBP = x USD) means GBP has appreciated against the USD, not depreciated
Wrong move:
Claiming that depreciation of the domestic currency always improves the trade balance
Why:
The effect of depreciation on the trade balance depends on the price elasticity of demand for exports and imports, per the Marshall-Lerner condition
Correct move:
Explain that depreciation will improve the trade balance only if the sum of the elasticity of demand for exports and imports is greater than 1
Wrong move:
Assuming no central bank intervention exists in floating exchange rate regimes
Why:
Very few countries have pure free-floating exchange rates; most operate a managed float
Correct move:
Note that managed floats allow occasional central bank intervention to reduce excessive volatility, while letting market forces determine the long-run value
5. Quick Reference Cheatsheet
Term | Regime | Definition |
|---|---|---|
Appreciation | Floating | Market-driven increase in currency value |
Depreciation | Floating | Market-driven decrease in currency value |
Revaluation | Fixed | Official policy increase in currency value |
Devaluation | Fixed | Official policy decrease in currency value |
Floating regime | Any | Value determined by market supply and demand |
Fixed regime | Any | Value set and maintained by central bank |
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.
- 2022 Β· 1
Effect of export growth on currency value
- 2023 Β· 2
Compare fixed vs floating regimes
Going deeper
What's Next
Exchange rates are a core building block for analyzing all other aspects of the global economy in IB Economics. Changes in exchange rates directly impact the balance of payments, the terms of trade, and key domestic macroeconomic outcomes like inflation, unemployment, and output. This knowledge is regularly tested in both paper 1 (essay) and paper 2 (data response) questions, so it is critical to master the terminology and analysis before moving on to more advanced global economy topics.