4.

5 Exchange rates
Learning objectives
4.5 Exchange rates Depth Diagrams and calculations

Floating exchange rates AO2 Diagram: showing the

• Determination AO4 exchange rate determination
• Depreciation and appreciation of a currency and changes in equilibrium in a
floating exchange rate system

Calculation: using exchange

rates, the price of a good in
different currencies
Learning objectives
4.5 Exchange rates Depth Diagrams and calculations

Changes in demand and supply for a currency – factors AO2 Calculation: changes in the value
including: AO4 of a currency from a set of data

• foreign demand for exports • remittances

• domestic demand for • speculation
imports • relative inflation rates
• inward/outward foreign • relative interest rates
direct investment • relative growth rates
• inward/outward portfolio • central bank intervention
investment
Learning objectives
4.5 Exchange rates Depth Diagrams and calculations

Consequences of changes in the exchange rate on economic AO3 Diagram: AD/AS curves to show
indicators, such as: AO4 potential consequences of
• the inflation rate changes in the exchange rate on
• economic growth the economy
• unemployment
• the current account balance
• living standards
Fixed exchange rate AO2 Diagram: showing how a fixed
• Devaluation and revaluation of a currency AO4 exchange rate is maintained
• How fixed exchange rates are maintained
Learning objectives
4.5 Exchange rates Depth Diagram and calculations

Managed exchange rates AO2 Diagram: showing the

• Overvalued currencies AO4 exchange rate determination
• Undervalued currencies and changes in equilibrium in a
managed exchange rate
system
Fixed versus floating exchange rate systems (HL AO3
only)
Real world example – data analysis
Open the following foreign exchange charts and select the time period under the chart as “All”
Source 1: USD/EUR Chart
Source 2: USD/HKD Chart

Data Analysis Questions

1. What do you notice from the data?

2. What questions do you wonder about the data?

3. Research information that may help you answer your questions from Q2.

4. What conclusions can you make from Q1, Q2, and Q3?
Introduction
International trade involves the use of different national currencies. National currencies are traded
for each other on the foreign exchange market and the value of one currency in terms of another is
known as the exchange rate.
Introduction
Every foreign exchange market involves a currency pair.
Examples: World’s most traded currency pairs.
Foreign exchange market

A foreign exchange market can be modelled

Market for Euros
Exchange
using a demand and supply diagram.
Rate ($/€)
S !"#$%

The y-axis represents the “price” or exchange

rate of one currency in terms of another. For
example, the exchange rate of Euros can be P*

expressed in US dollars i.e., the number of US

dollars required to purchase one Euro.
D !"#$%

The x-axis shows the quantity of Euros traded

Q* Quantity of €
for US dollars in this foreign exchange market.
Foreign exchange market - Stakeholders

Demand for Euros include USD holders e.g.,

Market for Euros
Exchange
consumers, firms, government, who are willing Rate ($/€)
S !"#$%
and able to exchange their USD to Euros.

Supply for Euros include Euro holders e.g.,

P*
consumers, firms, government, who are willing
and able to exchange their Euros to USD.

D !"#$%

Q* Quantity of €
Foreign exchange market

The exchange rate P* is determined by the Market for Euros

Exchange
equilibrium between demand and supply. Rate ($/€)
S !"#$%

The exchange rate for Euros is denoted by:

1 EUR = 𝑃∗ USD P*

D !"#$%

Q* Quantity of €
Foreign exchange market - Interdependence
Every foreign exchange market involves two currencies and subsequently two interdependent
markets. For example, the USD/EUR pair involves the market for Euros and the market for USD.

Market for Euros Market for USD

Exchange Exchange
Rate ($/€) Rate (€/$)
S !"#$% S &'(

P P*

D !"#$% D &'(

Q* Quantity of € Q* Quantity of $
Foreign exchange market - Interdependence
The two markets consists of the same group of stakeholders which make up the buyers and
sellers of both currencies.

Market for Euros Market for USD

Exchange Exchange
Rate ($/€) Rate (€/$)
S !"#$% S &'(

P P*

D !"#$% D &'(

Q* Quantity of € Q* Quantity of $
Foreign exchange market - Interdependence
The demand for Euros consisting of USD holders are also the suppliers of USD who are willing
and able to exchange their USD for Euros.

Market for Euros Market for USD

Exchange Exchange
Rate ($/€) Rate (€/$)
S !"#$% S &'(

P P*

D !"#$% D &'(

Q* Quantity of € Q* Quantity of $
Foreign exchange market - Interdependence
The supply for Euros consisting of Euro holders also make up the demand for USD who are
willing and able to exchange their Euros for USD.

Market for Euros Market for USD

Exchange Exchange
Rate ($/€) Rate (€/$)
S !"#$% S &'(

P P*

D !"#$% D &'(

Q* Quantity of € Q* Quantity of $
Foreign exchange market - Interdependence
If there is a change in demand or supply in one market, it is reflected in the other market.
Subsequently, if there is a change in the exchange rate in one market, it is reflected in the other.

Market for Euros Market for USD

Exchange Exchange
Rate ($/€) Rate (€/$)
S !"#$% S &'(

P P*

D !"#$% D &'(

Q* Quantity of € Q* Quantity of $
Foreign exchange market - Interdependence
Suppose there is an increase in interest rates in the EU. How would this affect the market for
Euros and the market for USD?

Market for Euros Market for USD

Exchange Exchange
Rate ($/€) Rate (€/$)
S !"#$% S &'(

P P*

D !"#$% D &'(

Q* Quantity of € Q* Quantity of $
Foreign exchange market - Interdependence
Demand for Euros increase as USD holders convert more USD to Euros to benefit from increased
returns to saving. This is reflected by an increase in supply for USD in the market for USD.

Market for Euros Market for USD

Exchange Exchange
Rate ($/€) Rate (€/$)
S !"#$% S &'(

P1
S2 &'(

P P*

P2
D1 !"#$%
D &'(
D !"#$%

Q* Q1 Quantity of € Q* Q2 Quantity of $
Foreign exchange market - Interdependence
The value of the Euro increases from P to P1 while the value of USD falls from P* to P2.

Market for Euros Market for USD

Exchange Exchange
Rate ($/€) Rate (€/$)
S !"#$% S &'(

P1
S2 &'(

P P*

P2
D1 !"#$%
D &'(
D !"#$%

Q* Q1 Quantity of € Q* Q2 Quantity of $
Foreign exchange market - Interdependence
Similarly, a fall in demand for Euros is equivalent to a fall in supply for the US dollar, vice versa.

Market for Euros Market for USD

Exchange Exchange
S2 &'( S &'(
Rate ($/€) Rate (€/$)
S !"#$%

P2

P P*

P1

D &'(
D !"#$%
D1 !"#$%
Q1 Q* Quantity of € Q2 Q* Quantity of $
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Hoang, Wray, & Chakraborty (2020)

Economics for the IB Diploma Programme

• Page 488-489

• Paper 2 and 3 Exam Practice Question 31.1, 31.2, 31.3,

and 31.4

• [2 marks] + [2+2 marks] + [2+2 marks] + [2 marks]

Exchange rate systems
There are three types of exchange rates systems.

Floating Fixed Managed

Floating Exchange Rates
In a floating exchange rate regime, the value of a currency is determined by market forces of
demand and supply without government intervention.
Floating Exchange Rates
Changes in demand and supply affects the equilibrium exchange rate.

Appreciation refers to the rise in the value of a currency in a floating exchange rate system.
Market for Euros Market for Euros
Exchange Exchange
Rate ($/€) Rate ($/€)
S !"#$% S1!"#$%
S !"#$%

P1 P1

P* P*

D1 !"#$%

D !"#$%
D !"#$%

Q* Q1 Quantity of € Q1 Q* Quantity of €
Floating Exchange Rates
Changes in demand and supply affects the equilibrium exchange rate.

Depreciation refers to the fall in the value of a currency in a floating exchange rate system.
Market for Euros Market for Euros
Exchange Exchange
Rate ($/€) Rate ($/€)
S!"#$%
S !"#$%

S1 !"#$%

P* P*

P1 P1

D !"#$%
D1 !"#$% D !"#$%

Q1 Q* Quantity of € Q* Q1 Quantity of €
Floating Exchange Rates – appreciation
When the value of the Euro increases, it is
known to appreciate and its exchange rate Market for Euros
Exchange
Rate ($/€)
increases i.e. it takes more USD to purchase S !"#$%
one Euro.

As with resource and product markets, the price P*

– or exchange rate – of a Euro will increase

either by:
D !"#$%

• A rise in demand for the Euro

Q* Quantity of €
• A fall in supply for the Euro
Floating Exchange Rates – appreciation
An increase in demand for Euros will increase
Market for Euros
its exchange rate from P* to P1 . Exchange
Rate ($/€)
S !"#$%
Why might the demand curve increase?
P1
• Increased demand for EU exports
P*
• Firms in the Eurozone expect to be
paid in Euros.
D1 !"#$%
• Hence, non-EU consumers demanding
D !"#$%
EU exports must purchase Euros
Q* Q1 Quantity of €
which increases demand.
Floating Exchange Rates – appreciation
An increase in demand for Euros will increase
Market for Euros
its exchange rate from P* to P1 . Exchange
Rate ($/€)
S !"#$%
Why might the demand curve increase?
P1
• Increased investment towards the
Eurozone P*

• Foreign firms fund FDI by purchasing

D1 !"#$%
the Euro
D !"#$%
• Foreign investors fund portfolio
Q* Q1 Quantity of €
investment by purchasing the Euro
Floating Exchange Rates – appreciation
An increase in demand for Euros will increase
Market for Euros
its exchange rate from P* to P1 . Exchange
Rate ($/€)
S !"#$%
Why might the demand curve increase?
P1
• Remittances from expatriates
P*
• Expatriates may remit their foreign
income back to the Eurozone
D1 !"#$%
• For remittances to be spent within the
D !"#$%
Eurozone, foreign currencies must be
Q* Q1 Quantity of €
converted into Euro
Floating Exchange Rates – appreciation
An increase in demand for Euros will increase
Market for Euros
its exchange rate from P* to P1 . Exchange
Rate ($/€)
S !"#$%
Why might the demand curve increase?
P1
• Speculation (hot money)
P*
• Currency speculators may purchase the
Euro, expecting its value to rise, allowing
D1 !"#$%
them to sell their Euro for a profit.
D !"#$%
• This leads to a self-fulfilling prophecy, as
Q* Q1 Quantity of €
it increases demand for the Euro, leading
it to appreciate, ceteris paribus.
Floating Exchange Rates – appreciation
An increase in demand for Euros will increase
Market for Euros
its exchange rate from P* to P1 . Exchange
Rate ($/€)
S !"#$%
Why might the demand curve increase?
P1
• A fall in relative inflation rates
P*
• When the inflation rate within the
Eurozone is lower than the global
D1 !"#$%
average, its exports will be relatively
cheaper than the rest of the world D !"#$%

Q* Q1 Quantity of €
• As a result, increased demand of the
Eurozone’s exports appreciates the Euro
Floating Exchange Rates – appreciation
An increase in demand for Euros will increase
Market for Euros
its exchange rate from P* to P1 . Exchange
Rate ($/€)
S !"#$%
Why might the demand curve increase?
P1
• A rise in relative interest or growth rates
P*
• Contractionary monetary policy increases
the incentive to save and earn interest
D1 !"#$%
payments
D !"#$%
• As a result, investors with accounts within
Q* Q1 Quantity of €
the Eurozone may exchange their foreign
currency to Euros, increasing demand
Floating Exchange Rates – appreciation
A fall in supply for Euros will also increase its
Market for Euros
exchange rate from P* to P1 . Exchange
Rate ($/€) S1!"#$%
S!"#$%
Why might the supply curve decrease?
P1
• A fall in domestic demand for imports
P*
• When residents of the Eurozone import
less goods and services, they exchange
less of their Euro for foreign currencies
D !"#$%
• As a result, the supply curve decreases.
Q1 Q* Quantity of €
Floating Exchange Rates – appreciation
A fall in supply for Euros will also increase its
Market for Euros
exchange rate from P* to P1 . Exchange
Rate ($/€) S1!"#$%
S!"#$%
Why might the supply curve decrease?
P1
• A fall in outward investment from the Eurozone
P*
• Eurozone firms fund outward FDI by selling
their Euro for foreign currencies

• Eurozone investors fund outward portfolio D !"#$%

investment also by selling their Euro

Q1 Q* Quantity of €
• Hence, a fall in outward investment will
reduce supply of the Euro.
Floating Exchange Rates – appreciation
A fall in supply for Euros will also increase its
Market for Euros
exchange rate from P* to P1 . Exchange
Rate ($/€) S1!"#$%
S!"#$%
Why might the supply curve decrease?
P1
• Central bank intervention
P*
• Central banks may restrict the supply of their
currency through administrative barriers

• Some currencies can only be legally traded

D !"#$%
from approved outlets
Q1 Q* Quantity of €
• This prevents governments or large groups of
investors from manipulating a given currency.
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Economics for the IB Diploma Programme

• Page 494

• Paper 2 and 3 Exam Practice Question 31.5

• [4 marks]
Floating Exchange Rates – depreciation
When the value of the Euro falls, it is known
Market for Euros
to depreciate and its exchange rate falls Exchange
Rate ($/€)
i.e. it takes less USD to purchase one Euro. S !"#$%

As with resource and product markets, the

price – or exchange rate – of the Euro falls P*

either by:

• A fall in demand for the Euro D !"#$%

• A rise in supply for the Euro

Q* Quantity of €
Floating Exchange Rates – depreciation
A fall in demand for Euros decreases its exchange
Market for Euros
rate from P* to P1 . Exchange
Rate ($/€)
S !"#$%
Why might the demand curve fall?

• A fall in demand for exports from the Eurozone

P*
• A fall in inward direct and portfolio investment

• A fall in remittances P1

• Speculation that the exchange rate will fall D !"#$%

D1 !"#$%
• A rise in relative inflation rates
Q1 Q* Quantity of €
• A fall in relative interest and growth rates
Floating Exchange Rates – depreciation
A rise in supply for Euros will also decrease its
Market for Euros
exchange rate from P* to P1 . Exchange
Rate ($/€)
S !"#$%
Why might the supply curve rise?

• An increase in domestic demand for imports S1 !"#$%

P*
• An increase in outward investment from the
Eurozone P1

• A fall in central bank intervention

D !"#$%

Q* Q1 Quantity of €
Real world example – factors affecting exchange rates
Article: US dollar-yuan exchange rate: what is it and why is it important?

With reference to the article, explain factors which has affected the supply and demand of USD/CNY.
Consequences of Changes in Floating Exchange Rates
The consequences of changes in exchange rates can be remembered through the following
mnemonic:

E - Economic Growth
L - Living Standards
I - Inflation
T - Trade Balance (Net Exports)
E - Employment
Consequences of Depreciation
Depreciation in the exchange rate will:

• Make a country’s exports cheaper to foreign GPL Demand-pull Inflation

consumers
AS
• Make imports more expensive to domestic
consumers
P)

• Overall, this improves a country’s trade

AD2
balance (X – M) and subsequently AD, P*
increasing economic growth Y! → Y" . AD1

• However, a rise in AD may lead to demand- Y* Y) Real GDP

pull inflation.
Consequences of Depreciation

GPL Cost-push Inflation

Furthermore, imported factors of production will be
AS+ AS,
more expensive, reducing producers’ willingness
to produce.

P)
This leads to cost-push inflation as aggregate
supply shifts inwards. P*

AD
Y) Y* Real GDP
Consequences of Appreciation
An appreciation in the exchange rate will:
• Make a country’s exports more expensive to GPL Cost-push Inflation
foreign consumers
AS
• Make imports cheaper to domestic consumers
• Overall, this worsens a country’s trade balance,
decreasing economic growth and hence
AD2
standards of living.
P*
• Due to lower AD, producers will produce at a P)
AD1
lower level of output Y! → Y"
Y) Y* Real GDP
• As the economy is below full capacity, this leads
to unemployment.
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Hoang, Wray, & Chakraborty (2020)

Economics for the IB Diploma Programme

• Page 497

• Paper 1 Exam Practice Question 31.6

• [10 + 15 marks]
Fixed Exchange Rates
A fixed exchange rate system is one where the central bank and/or government of an economy
fixes the value of the national currency to the value of another currency at a particular level.
Examples: Top Exchange Rates Pegged to the U.S. Dollar
Fixed Exchange Rates
The central bank and/or the government must actively intervene in the foreign exchange market in
order to influence demand and supply of the currency to maintain the exchange rate at the
predetermined level. Intervention may take several forms:

• Buying and selling official reserves

• Changing interest rates

• Import controls
Fixed Exchange Rates
An example of a fixed or pegged exchange rate
is the Hong Kong Dollar against the US Dollar. Market for Hong Kong Dollars
Exchange
Rate
Suppose there is a fall in demand for the HKD (US$/HK$)
S -.(
(D1 → D2 ), resulting in downward pressure on
the exchange rate. In a floating exchange rate
P1
system, the exchange rate would depreciate
from P1 → P2 . P2

D1 -.(
In order to maintain the fixed exchange rate D2 -.(
value at P1, Hong Kong’s de facto central bank
Q2 Q1 Quantity of $
(HKMA) must intervene in the market.
Fixed Exchange Rates
Official reserves
Market for Hong Kong Dollars

Following a fall in demand in HK dollars from Exchange

Rate
D1 → D2 , the HKMA can sell some of its foreign (US$/HK$)
S -.(

currency reserves (USD) and purchase HK

dollars to increase demand back to D1 from D2. P1

P2
This allows the value of the HK dollar to be
D1 -.(
maintained at the predetermined level of P1.
D2 -.(

Q2 Q1 Quantity of $
Fixed Exchange Rates
Changing interest rates
Market for Hong Kong Dollars

Following a fall in demand in HK dollars from Exchange

Rate
D1 → D2 , the HKMA can increase domestic (US$/HK$)
S -.(

interest rates to raise the demand for HK

dollars, as the return of saving in HK dollars P1

increase. P2

D1 -.(
This allows the value of the HK dollar to be
D2 -.(
maintained at the predetermined level of P1.
Q2 Q1 Quantity of $
Fixed Exchange Rates
Import controls
Market for Hong Kong Dollars

Following a fall in demand in HK dollars from Exchange

S2 -.(
Rate
D1 → D2 , the Hong Kong government can (US$/HK$)
S1 -.(

impose protectionist policies to limit imports.

This reduces the supply of HK dollars from S1 P1

to S2. P2
D1 -.(

This allows the value of the HK dollar to be D2 -.(

maintained at the predetermined level of P1.

Q3 Q2 Q1 Quantity of $
Fixed Exchange Rates
Devaluation occurs when the central bank or the government reduces the predetermined value of
a currency in a fixed exchange rate system.

Revaluation occurs when the central bank or the government increases the predetermined value
of a currency in a fixed exchange rate system.

The economic consequences of devaluation and revaluation are similar to depreciation and
appreciation, respectively.
Evaluation of Floating and Fixed Exchange Rates (HL only)
The arguments for and against fixed and floating
exchange rate systems include:

• Certainty

• Opportunity costs
• Currency liquidity

• Speculation

• Monetary policy
Certainty (HL only)

Fixed exchange rates offer stability, reducing

concerns with fluctuations which may lead to a
losses for consumers and producers.

As a result, fixed exchange rates often encourages

foreign direct investment as it reduces the exchange
rate risk for firms.
Opportunity Costs (HL only)

Fixed exchange rates often encourage the

improvement of a country’s long-term international
competitiveness, as a fixed exchange rate system
reduces market volatility.

In a freely floating exchange rate system, long term

improvements to international competitiveness would
appreciate the currency, partially negating the effects
of any reform.
Opportunity Costs (HL only)

As fixed exchange rates are constant, there is more

incentive to improve a country’s intrinsic international
competitiveness.

However, central banks will need to hold foreign

reserves, incurring an opportunity cost. Furthermore,
a significant amount of time is needed to monitor the
market and engage revaluations and devaluations.
Currency Liquidity (HL only)

Currency liquidity refers to the availability of currency

in a market.

The holding of foreign reserves by central banks

reduces the availability of currencies on global
markets for private investors.

Overall, this crowds out private investors that may

have invested in global economies.
Speculation (HL only)

Floating exchange rates are subject to speculation

where investors may buy or sell a currency
depending on their beliefs on the future value of
the currency.

This often leads to fluctuations in the exchange

rate and increases volatility and uncertainty.
Monetary Policy (HL only)

Under a fixed exchange rate system, central banks

adjust interest rates to influence their exchange rate.

As a result, there is less to no freedom to use

monetary policy to achieve macroeconomic aims.
Over to you…

Hoang, Wray, & Chakraborty (2020)

Economics for the IB Diploma Programme

• Page 504

• Paper 3 Exam Practice Question 31.7

• [1 + 2 marks]
Managed Exchange Rate
A managed exchange rate system incorporates elements of both a floating and fixed exchange
rate, where the currency is primarily subject to free market forces, with occasional central bank or
government intervention to prevent large fluctuations.
Managed Exchange Rates
A managed exchange rate is similar to a floating exchange rate system. However, the central
bank intervenes to keep the exchange rate within a range known as a crawling peg.

It is sometimes known as a dirty float as exchange rates are primarily floating with some
government intervention.

Most major currencies follow a managed exchange rate system such as the US Dollar, Euro,
British Pound, and Japanese Yen.
Managed Exchange Rates

Market for Euros

Exchange
Rate ($/€) S1!"#$%

S2 !"#$%
When the exchange rate is close to its upper
P2
upper bound
bound, the ECB may occasionally buy foreign
P1
currencies, increasing the supply of Euros to
lower bound
keep their exchange rate within the bounds.
D2 !"#$%

D1 !"#$%

Q1 Q2 Q3 Quantity of €
Managed Exchange Rates

Market for Euros

Exchange
Rate ($/€)
S1 !"#$%
When the exchange rate is close to its lower
bound, the ECB may occasionally sell its upper bound

foreign reserves to buy back its Euro, P1

increasing the demand of Euros to keep their P2

lower bound

exchange rate within the bounds. D1 !"#$%

D2 !"#$%

Q2 Q1 Quantity of €
Managed Exchange Rates
An overvalued currency is one that has been managed at a value higher than its true floating
exchange rate value.

An undervalued currency is one that has been managed at a value lower than its true floating
exchange rate value.

The economic consequences of an overvalued and undervalued are similar to

depreciation/devaluation and appreciation/revaluation, respectively.
Real world example – the Chinese Yuan
Watch the video from 9:22 and answer the following questions

1. Explain how and why China manipulates its currency.

2. Discuss whether currency manipulation is fair to society at large?

Test your knowledge on this unit: Kahoot!