IB DP Economics: Exchange rates – Revision Notes

These notes condense exchange rates, sub-topic 4.5 of Unit 4 (The global economy), for the final weeks of revision. They follow the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. Everything is for SL and HL except the fixed versus floating comparison, which is HL only. For full explanations and worked examples, read the study guide, then test yourself with the practice set.

The examples use Pelland (currency the pel) and Dunmark (currency the dun). Both are invented and the figures are illustrative. The rate is quoted as duns per pel. Links: IB DP Economics course page, printable checklist and the free 10-minute diagnostics.

Definitions

Term	Meaning
Exchange rate	How much of one currency buys a unit of another
Floating	Rate set by market demand and supply, with no official target
Appreciation / depreciation	A rise / fall in a currency’s market value under a floating system
Fixed	Government sets an official rate and the central bank defends it
Revaluation / devaluation	An official rise / cut in a fixed rate
Managed	Rate floats, but the central bank intervenes to influence it
Overvalued / undervalued	Rate above / below the level the market alone would set

Formulas

Task	Method
Foreign price of a home good	Home price x rate (foreign currency per home unit)
Home price of a foreign good	Foreign price / rate
Value of the other currency	1 / rate
Percentage change	(new - old) / old x 100
Cost of defending a peg	Excess quantity x pegged rate

Worked reminder. An 80-pel good at 1.50 duns per pel costs 80 x 1.50 = 120 duns. If the rate falls to 1.35, the change is (1.35 - 1.50) / 1.50 x 100 = -10%, a depreciation of the pel, and the good costs 108 duns.

Floating system: method in steps

1. Axes: exchange rate (duns per pel) up, quantity of pels along.
2. Draw demand sloping down and supply sloping up. Label equilibrium rate and quantity.
3. Decide which curve a cause shifts. Shift only that one.
4. Read off the new rate. A higher rate is appreciation, a lower rate is depreciation.

Factors that move a currency

Cause	Demand for the pel	Supply of the pel	Result
Foreign demand for exports rises	Right		Appreciation
Domestic demand for imports rises		Right	Depreciation
Inward FDI or portfolio investment	Right		Appreciation
Outward FDI or portfolio investment		Right	Depreciation
Remittances sent in	Right		Appreciation
Remittances sent out		Right	Depreciation
Speculators expect a rise	Right		Appreciation
Higher inflation than partners	Left	Right	Depreciation
Higher interest rates than partners	Right		Appreciation
Faster growth than partners		Right (more imports)	Depreciation, unless investment inflows dominate
Central bank buys pels	Right		Appreciation
Central bank sells pels		Right	Depreciation

Consequences of a change in the rate

Indicator	Depreciation	Appreciation
Inflation	Rises: dearer imports, higher input costs	Eases: cheaper imports
Growth	Rises if X - M increases (AD right)	Slows if X - M falls (AD left)
Unemployment	Tends to fall	Tends to rise
Current account	Improves if trade responds enough, may worsen if not	Opposite
Living standards	Imports dearer, but more jobs	Imports cheaper, but possible job losses

AD/AS sketch for a depreciation: AD shifts right, and SRAS shifts left if imported inputs matter. Price level rises either way. Real GDP rises only if the AD shift is larger.

Fixed and managed systems: method in steps

1. Draw the market with the usual demand and supply.
2. Mark the official or target rate as a horizontal line.
3. Above equilibrium: the currency is overvalued, supply exceeds demand, and the central bank must buy its currency.
4. Below equilibrium: undervalued, demand exceeds supply, and the central bank must sell its currency.
5. The quantity is the horizontal gap between D and S on that line.
6. Tools: trade the currency using reserves, change interest rates, or restrict foreign exchange transactions.

Worked reminder. Pelland pegs at 1.80 while the market would give 1.50, with 60 million pels of excess supply. The bank buys 60 million pels and spends 60 x 1.80 = 108 million duns of reserves. Reserves are finite, so an overvalued peg cannot be held indefinitely without a policy change.

Second reminder, for a managed system. Demand for pels rises and the market rate would be 1.70, but the bank holds it at 1.60. The pel is undervalued compared with the market rate, so demand exceeds supply at 1.60. The bank sells pels, and its reserves of duns grow. Name the direction of intervention and the effect on reserves.

Writing the answers

• Explain a change in the rate. Name the factor, state which curve shifts and which way, state the new rate, then name the result as appreciation or depreciation. Four short steps give a clear, complete explanation.
• Examine consequences. Choose the indicators the question names. For each, give the chain from the rate to the price of exports or imports, then to AD or SRAS, then to the indicator. Add a condition, such as how strongly buyers respond, and a stakeholder who gains or loses.
• Calculate. Write the formula, substitute, and give the answer with the currency or the percent sign. Show the working even when the answer looks obvious.
• Evaluate fixed against floating (HL only). Pick two or three criteria, compare the systems on each, and finish with a judgement tied to the country in the question.
• Use the context. The guide’s inquiry suggestions ask you to study a chosen country, so know one case where a government manages its rate and be ready to say why and how.

Must-know distinctions

• Depreciation vs devaluation. Depreciation is a market fall under a floating system. Devaluation is an official cut under a fixed one.
• Overvalued vs appreciated. Overvalued means above the market-clearing level. Appreciation means a rise over time.
• Fixed vs managed. A fixed rate is held at an official level. A managed rate is influenced but still moves.
• Pel vs dun. A rise in the pel’s rate is a fall in the dun’s value. The percentage changes are not the same.

Fixed versus floating (HL only)

Criterion	Fixed	Floating
Certainty	Greater if believed	Less, rates move
Monetary policy	Tied to the peg	Free for domestic goals
Reserves	Large needed	Small needed
Imbalances	Reserves or devaluation	Adjust through the rate
Speculation	Risk of attack on a weak peg	Volatility

Reach a judgement: it depends on the size of the economy, its trade dependence and its reserves.

Quick self-test

1. Define depreciation of a currency under a floating system.
2. A 90-dun good in Dunmark is sold in Pelland at 1.50 duns per pel. State its price in pels.
3. The rate falls from 1.50 to 1.35 duns per pel. Calculate the percentage change in the pel.
4. The rate is 1.50 duns per pel. State the value of one dun in pels, to 3 significant figures.
5. State two causes of an increase in demand for the pel.
6. Pelland’s inflation rises above its trading partners’. Explain the effect on the pel under a floating system.
7. A peg of 1.80 is above the market rate. State whether the pel is overvalued or undervalued and what the central bank must do.
8. The peg is cut from 1.50 to 1.20. Name this change and calculate the percentage change.
9. Explain one reason a depreciation might worsen the current account.
10. (HL only) State one advantage of a fixed system and one of a floating system.

Answers

1. A fall in the market value of the currency in terms of another, set by supply and demand.
2. 90 / 1.50 = 60 pels.
3. (1.35 - 1.50) / 1.50 x 100 = -10%.
4. 1 / 1.50 = 0.6667, so 0.667 pels.
5. Any two: higher export demand, inward FDI or portfolio investment, remittances in, expected appreciation, higher interest rates, central bank purchases.
6. Pelland’s exports become less competitive and imports more attractive, so demand falls and supply rises. The pel depreciates.
7. Overvalued. Supply exceeds demand at the peg, so the bank must buy pels.
8. A devaluation: (1.20 - 1.50) / 1.50 x 100 = -20%.
9. If quantities traded respond little to price, the higher import bill outweighs the extra export revenue.
10. Fixed: greater certainty for trade. Floating: freedom to use interest rates for domestic goals, and no need for large reserves.

Where marks are usually lost

• Axes without units or a currency pair.
• Shifting the wrong curve, or shifting both.
• Writing devaluation for a market fall, or depreciation for an official cut.
• Dividing when you should multiply, or reversing the quote.
• Taking the percentage change for the wrong currency.
• Stating that a depreciation always improves the current account.
• Describing consequences without linking them to AD or SRAS.
• Listing fixed and floating features in the HL question without a judgement.

Back to the study guide.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization, February 2020, sub-topic 4.5.