IB DP Economics: Exchange rates

This guide covers exchange rates, sub-topic 4.5 of Unit 4 (The global economy). It follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. Almost all of 4.5 is for both SL and HL. The comparison of fixed and floating exchange rate systems is HL only and is marked that way below.

All figures belong to Norland, whose currency is the nor, and Estovia, whose currency is the esto. Both are invented and every number is illustrative, not real data. Use the revision notes to consolidate and the practice set to test yourself. The course page is IB DP Economics, the printable checklist lets you tick off each point, and the free diagnostics show where to start.

What 4.5 asks you to do

Content	What you must be able to do	Level
Floating rates	Explain determination, depreciation and appreciation; draw the currency market diagram; convert prices	SL and HL
Changes in demand and supply	Explain the factors the guide lists and calculate changes in value from data	SL and HL
Consequences	Use AD/AS to examine effects on inflation, growth, unemployment, the current account and living standards	SL and HL
Fixed rates	Explain devaluation, revaluation and how a fixed rate is maintained, with a diagram	SL and HL
Managed rates	Explain overvalued and undervalued currencies, with a diagram	SL and HL
Fixed versus floating	Evaluate the two systems	HL only

The guide sets the first, second, fourth and fifth rows at application and analysis (AO2) with calculation and diagram skills (AO4). Consequences and the HL comparison sit at the evaluation level (AO3), so you need to weigh points, not only list them. The guide describes Paper 2 as a data response paper that includes some quantitative questions, so expect to calculate.

Floating exchange rates

An exchange rate states how much of one currency buys a unit of another. This guide quotes it as estos per nor, so a rate of 2.00 means 1 nor buys 2 estos. In a floating system the market for foreign exchange decides the rate through buyers and sellers of the currency, and nobody sets an official target.

The currency market diagram

Draw the market for the nor:

Exchange rate
(estos per nor)
  |
  |   \               /
  |    \            /
  |     \         /
2.00 - - - - - X - - - - -
  |         /    \
  |       /        \
  |     /            \
  |   S                D
  +--------------------------
                280   Quantity of nors
                      (millions per day)

• The vertical axis is the price of the nor in estos. The horizontal axis is the quantity of nors traded per day.
• Demand for nors slopes downwards. A higher rate makes Norland’s exports dearer to Estovians, so they need fewer nors.
• Supply of nors slopes upwards. A higher rate makes imports cheaper for Norland, so more nors are offered to buy estos.
• Equilibrium is where the curves cross. Label the rate and the quantity.

Appreciation is a rise in the market value of a currency under a floating system. Depreciation is a fall. Appreciation of the nor means depreciation of the esto, because they are two sides of one price.

Worked example (equilibrium and a shift). In Norland the demand for nors is Qd = 400 - 60e and the supply is Qs = 100 + 90e, where e is the rate in estos per nor and quantities are in millions per day.

1. Set Qd = Qs: 400 - 60e = 100 + 90e, so 300 = 150e and e = 2.00.
2. Quantity: 400 - 60(2.00) = 280 million nors.
3. Foreign demand for Norland’s exports rises, and demand becomes Qd = 460 - 60e. Then 460 - 60e = 100 + 90e, so 360 = 150e and e = 2.40.
4. Quantity: 100 + 90(2.40) = 316 million nors.

The demand curve shifted right and the nor appreciated from 2.00 to 2.40.

Prices in different currencies

Foreign price = home price x exchange rate (estos per nor). A Norland good costs 45 nors.

• At 2.00 it costs 45 x 2.00 = 90 estos.
• At 2.25 it costs 45 x 2.25 = 101.25 estos.
• At 1.80 it costs 45 x 1.80 = 81 estos.

To price an Estovian good in nors, divide by the rate. A good costing 63 estos costs 63 / 2.00 = 31.5 nors, and 63 / 2.25 = 28 nors after the nor appreciates.

Calculating changes in value

Percentage change = (new - old) / old x 100.

• The nor moves from 2.00 to 2.25 estos: (2.25 - 2.00) / 2.00 x 100 = +12.5%.
• The esto’s value in nors moves from 1/2.00 = 0.5 to 1/2.25 = 0.444, a change of -11.1%. The two percentages are not equal, so name the currency you are measuring.

From a series, calculate each step from the rate before it. A rate that runs 2.00, 2.20, 1.98 and 2.079 over four years rises 10%, falls 10% and rises 5%. Over the whole period it rose (2.079 - 2.00) / 2.00 x 100 = 3.95%. A 10% rise followed by a 10% fall does not return you to the start: 2.20 falls to 1.98, not 2.00.

What shifts demand and supply

The guide lists ten items. For each, decide whether it changes the demand for the nor or the supply of nors, then the direction.

Factor	Effect on the nor	Reason
Foreign demand for exports	Demand rises, so the nor appreciates	Foreign buyers need nors to pay
Domestic demand for imports	Supply rises, so the nor depreciates	Norland sells nors to buy foreign currency
Inward FDI and portfolio investment	Demand rises	Foreign investors buy nors to buy assets
Outward FDI and portfolio investment	Supply rises	Norland investors sell nors to buy foreign assets
Remittances	Inflows raise demand; outflows raise supply	Migrants’ transfers are converted across currencies
Speculation	Expected appreciation raises demand; expected depreciation raises supply	Traders buy what they expect to gain value
Relative inflation rates	Higher Norland inflation lowers demand and raises supply	Exports lose competitiveness, imports gain it
Relative interest rates	Higher Norland rates raise demand	Funds move to earn more, which is portfolio investment
Relative growth rates	Faster Norland growth raises import demand, so supply rises	Rising incomes buy more imports
Central bank intervention	Buying nors raises demand; selling nors raises supply	The bank trades in the market itself

Relative growth is not one-way. Faster growth can also attract inward investment, so state which effect you argue. Speculation can be self-fulfilling: if traders expect a fall, their selling causes it.

Consequences of exchange rate changes

The guide asks you to examine effects on five indicators and draw AD/AS curves. Take a depreciation of the nor.

• Inflation. Imports cost more in nors, which raises prices directly. Imported inputs raise costs, so short-run aggregate supply (SRAS) shifts left. Rising export demand adds to demand-pull pressure.
• Growth. Exports cost less to Estovians and imports cost more to Norland. If foreign buyers respond strongly, net exports (X - M) rise and aggregate demand (AD) shifts right, raising real GDP.
• Unemployment. Higher output in export and import-competing firms creates jobs, so unemployment tends to fall.
• Current account. The balance on goods and services tends to improve if the quantities traded respond enough to the price change. If they respond little, the import bill rises and the balance can worsen.
• Living standards. Imported goods and holiday abroad become dearer, which cuts real purchasing power. More jobs may offset this.

On the AD/AS diagram, draw AD1 shifting right to AD2 and, for imported costs, SRAS1 shifting left to SRAS2. Real GDP rises if the AD shift dominates, and the price level rises in either case. An appreciation does the reverse: imports are cheaper and inflation eases, but exporters lose competitiveness, growth slows and the current account may weaken. Different stakeholders gain and lose, so a good answer names them: exporters, importers, consumers, tourists, firms with foreign debts.

Fixed exchange rates

In a fixed system the government sets an official rate and the central bank defends it. A devaluation is an official cut in the rate and a revaluation is an official rise. Under a floating system the same moves are depreciation and appreciation.

Worked example (defending a peg). Norland pegs at 2.40 estos per nor, using the demand and supply from earlier (Qd = 400 - 60e, Qs = 100 + 90e).

1. At 2.40, Qd = 400 - 60(2.40) = 256 and Qs = 100 + 90(2.40) = 316 million nors.
2. Supply exceeds demand by 60 million nors. The market rate would be 2.00, so the nor is overvalued at the peg.
3. The central bank must buy 60 million nors, paying 60 x 2.40 = 144 million estos from its reserves.

On the diagram draw a horizontal line at 2.40 above equilibrium. The gap between S and D along that line is the quantity the bank must buy. If the peg were 1.60, the nor would be undervalued: Qd = 304 and Qs = 244, so demand exceeds supply by 60 million. The bank would sell 60 million nors and gain 60 x 1.60 = 96 million estos of reserves.

The ways to maintain a fixed rate:

• Buy or sell the currency using foreign exchange reserves, as above.
• Change interest rates. Higher rates attract portfolio investment and raise demand for the currency. Lower rates do the opposite.
• Restrict or tax foreign exchange transactions where the government chooses to.

Reserves are finite. A country defending an overvalued rate runs them down, which is why it may devalue instead. Worked devaluation: cutting the peg from 2.40 to 2.10 is a change of (2.10 - 2.40) / 2.40 x 100 = -12.5%. A 45-nor good falls from 108 to 94.5 estos, also -12.5%, so exports become cheaper.

Managed exchange rates

In a managed system the rate floats, but the central bank intervenes to influence it. The currency is overvalued when its rate is above the level the market alone would set, and undervalued when below.

Worked example (smoothing a rise). Foreign demand lifts demand to Qd = 460 - 60e, so the market rate would be 2.40. Norland’s central bank wants 2.20.

1. At 2.20, Qd = 460 - 132 = 328 and Qs = 100 + 198 = 298 million nors.
2. Demand exceeds supply by 30 million nors. At 2.20 the nor is undervalued compared with the market rate of 2.40.
3. The bank sells 30 million nors and gains 30 x 2.20 = 66 million estos of reserves.

On the diagram show the new demand curve, the market equilibrium at 2.40, the target at 2.20 and the horizontal gap between D and S. Governments may hold a currency down to protect exporters, or hold it up to limit import prices. Each has costs: reserves, inflation from the money created when the bank sells its own currency, or retaliation by trading partners.

Fixed versus floating (HL only)

Evaluate the two systems against criteria rather than listing them.

Criterion	Fixed	Floating
Certainty for trade and investment	Greater, if the peg is believed	Lower, rates move daily
Monetary policy	Interest rates must serve the peg	Free to target domestic goals
Adjustment	Needs reserves, or devaluation	Rate moves to correct imbalances
Reserves	Large reserves needed	Little needed
Speculation	A weak peg invites attack	Exposed to volatility
Inflation discipline	Can import a partner’s low inflation	Depreciation can raise import prices

A judgement depends on context: a small, trade-dependent economy may value stability, while a large economy with its own cycle may value policy freedom.

Common errors

• Drawing the axis as “price” or “exchange rate” with no units or currency pair.
• Shifting the wrong curve, for example a rise in imports moving demand for the currency.
• Applying a percentage change to the wrong currency.
• Calling a market move a devaluation, or an official move a depreciation.
• Saying a depreciation always improves the current account, without any condition.
• Describing intervention without saying whether the bank buys or sells its own currency.

The link between the current account and the exchange rate is taught in sub-topic 4.6, in the balance of payments guide.

Next: revision notes and the practice set.

Official syllabus

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