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IB DP Economics — Unit 4: The Global Economy | SL | 4.5 Exchange Rates
📋 What You Will Learn
- Explain the consequences of exchange rate changes for exporters, importers, inflation, and economic growth
- Analyse how currency appreciation and depreciation affect a country's current account balance
- Define fixed and managed exchange rate systems and explain how they are maintained
- Evaluate the advantages and disadvantages of fixed versus floating exchange rate systems
- Apply the Marshall-Lerner condition and J-curve effect to assess the impact of depreciation on the current account
- Assess the policy trade-offs governments face when choosing an exchange rate regime
🔍 Guiding Question When a country's currency loses value, is that always bad news — or can depreciation be a powerful tool for economic recovery?
🌍 Why This Matters In 2023, the Egyptian pound lost over 50% of its value against the US dollar as Egypt faced a severe balance of payments crisis, forcing the government to abandon its managed peg and allow the currency to float. Meanwhile, Japan's yen fell to a 33-year low against the dollar, making Japanese exports cheaper but pushing up import costs and domestic inflation. Exchange rate movements are not abstract — they determine the price of everything a country buys and sells from the rest of the world.
1. Consequences of Exchange Rate Changes
An exchange rate is the price of one currency expressed in terms of another. When this price changes — through appreciation or depreciation — it ripples through every part of the open economy: export competitiveness, import prices, inflation, and the current account balance all shift.
📖 Definition — Appreciation A currency appreciates when its value rises relative to another currency — meaning one unit of the domestic currency now buys more units of a foreign currency. Under a floating system, this occurs when demand for the currency rises or supply falls.
📖 Definition — Depreciation A currency depreciates when its value falls relative to another currency — meaning one unit of the domestic currency now buys fewer units of a foreign currency. Under a floating system, this occurs when supply of the currency rises or demand falls.
📌 Terminology Note In a floating exchange rate system, currencies appreciate and depreciate (market-driven). In a fixed exchange rate system, governments revalue (raise) or devalue (lower) the currency by official policy decision. Use the correct term for the correct system — examiners notice.
1.1 Effects of Currency Depreciation
On Exports
- Depreciation makes exports cheaper in foreign currency terms — foreign buyers pay less for the same good
- This improves price competitiveness of domestic exports in world markets
- If foreign demand is price-elastic, export volumes rise significantly → export revenue in domestic currency increases
- Example: if the pound depreciates from £1 = $1.40 to £1 = $1.20, a UK good priced at £100 falls from $140 to $120 for US buyers
On Imports
- Depreciation makes imports more expensive in domestic currency terms — domestic buyers pay more for the same foreign good
- If domestic demand for imports is price-elastic, import volumes fall → import expenditure in domestic currency may fall
- If import demand is inelastic (e.g. oil, food), import expenditure rises — worsening the current account
- Example: if the pound depreciates, the price of imported oil rises in sterling, increasing the UK's import bill
On Inflation
- Depreciation is inflationary — it raises the domestic price of imported goods and raw materials
- This is called imported inflation or cost-push inflation — firms face higher input costs and raise prices
- Higher import prices also feed directly