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IB DP Economics — Unit 4: The Global Economy | SL | 4.5 Exchange Rates
📋 What You Will Learn
- Define a floating exchange rate and explain how it is determined by the forces of demand and supply in the foreign exchange market
- Identify and explain the factors that cause the demand for and supply of a currency to shift, leading to appreciation or depreciation
- Analyse the effects of exchange rate changes on a country's exports, imports, inflation, and current account balance
- Apply the exchange rate mechanism to real-world economic scenarios involving trade flows and capital movements
- Calculate exchange rates, cross-rates, and the value of trade transactions using given data
- Evaluate the advantages and disadvantages of a floating exchange rate system for an economy
🔍 Guiding Question To what extent does a freely floating exchange rate serve as an automatic stabiliser for an open economy, and what are the limits of this self-correcting mechanism?
🌍 Why This Matters In 2022–2023, the Japanese yen fell to its weakest level against the US dollar in over 30 years — at one point trading at ¥150 per dollar. Japanese exporters celebrated as their goods became cheaper abroad, but Japanese households faced surging import costs for food and energy. A single number — the exchange rate — simultaneously helped some and hurt others. Understanding how that number is determined, and what moves it, is essential for analysing any open economy.
What Is a Floating Exchange Rate?
Every time a country trades goods, services, or financial assets internationally, its currency must be exchanged for another. The price at which this exchange takes place is the exchange rate. In a floating system, no government or central bank sets this price — it is determined entirely by market forces.
📖 Definition — Exchange Rate The exchange rate is the price of one currency expressed in terms of another currency. For example, if £1 = $1.27, the exchange rate of the pound sterling against the US dollar is 1.27.
📖 Definition — Floating Exchange Rate A floating (or flexible) exchange rate is a system in which the value of a currency is determined solely by the forces of demand and supply in the foreign exchange (forex) market, with no government or central bank intervention to fix or peg the rate.
- The foreign exchange market is a global, decentralised market where currencies are bought and sold 24 hours a day
- The exchange rate is the equilibrium price at which the quantity of a currency demanded equals the quantity supplied
- When the exchange rate rises (currency becomes more expensive), this is called appreciation
- When the exchange rate falls (currency becomes cheaper), this is called depreciation
- Both appreciation and depreciation are automatic market responses — no policy action is required
📖 Definition — Appreciation Appreciation occurs when the value of a currency rises relative to another currency under a floating exchange rate system — it can now buy more units of the foreign currency. For example, if the pound moves from £1 = $1.20 to £1 = $1.35, the pound has appreciated.
📖 Definition — Depreciation Depreciation occurs when the value of a currency falls relative to another currency under a floating exchange rate system — it now buys fewer units of the foreign currency. For example, if the pound moves from £1 = $1.35 to £1 = $1.20, the pound has depreciated.
📌 Appreciation vs Revaluation / Depreciation vs Devaluation Appreciation and depreciation refer to market-driven changes under a floating system. Revaluation and devaluation refer to deliberate government/central bank adjustments under a fixed or managed exchange rate system. Do not confuse these terms — they carry different implications for policy.
Demand for a Currency
To understand what determines the exchange