Core idea: exchange rates

· Exchange rate = the price of one currency in terms of another currency.
· In a floating exchange rate system, the value of a currency is determined by demand and supply in the foreign exchange market.
· In a fixed exchange rate system, the government or central bank sets a target value for the currency and uses intervention to keep it there.
· In a managed exchange rate system, the currency is mainly market-determined, but the central bank sometimes intervenes to influence its value.
· Exam focus: always identify which currency is being discussed, whether it appreciates/depreciates or is revalued/devalued, and whether the system is floating, fixed, or managed.

This diagram shows the market for foreign exchange, with demand and supply determining the equilibrium exchange rate. It is useful for explaining appreciation and depreciation in a floating exchange rate system. Source

Floating exchange rates: determination and changes

· Demand for a currency comes from foreigners wanting to buy the country’s exports, assets, or make investments there.
· Supply of a currency comes from domestic residents wanting to buy imports, foreign assets, or invest abroad.
· If demand for the currency rises, the currency appreciates in a floating system.
· If supply of the currency rises, the currency depreciates in a floating system.
· On the standard diagram: vertical axis = exchange rate/price of currency; horizontal axis = quantity of currency.
· An appreciation is shown by a movement to a higher equilibrium exchange rate.
· A depreciation is shown by a movement to a lower equilibrium exchange rate.

What changes demand and supply for a currency?

· Foreign demand for exports: higher foreign demand for domestic exports → demand for domestic currency rises → appreciation.
· Domestic demand for imports: higher demand for imports → supply of domestic currency rises → depreciation.
· Inward FDI: foreign firms investing domestically → demand for domestic currency rises.
· Outward FDI: domestic firms investing abroad → supply of domestic currency rises.
· Inward portfolio investment: foreigners buying domestic financial assets → demand rises.
· Outward portfolio investment: domestic residents buying foreign financial assets → supply rises.
· Remittances: money sent into the country tends to increase demand for the currency; money sent out tends to increase supply.
· Speculation: if traders expect a currency to rise, they buy it now → demand rises; if they expect it to fall, they sell it → supply rises.
· Relative inflation rates: higher inflation than other countries usually makes exports less competitive → lower demand and/or higher supply of the currency → depreciation.
· Relative interest rates: higher interest rates may attract foreign financial capital → demand rises → appreciation.
· Relative growth rates: strong domestic growth may increase imports → supply rises; but it may also attract investment → effect depends on which force is stronger.
· Central bank intervention: even in a floating or managed system, the central bank can buy or sell currency to influence its value.

Appreciation vs depreciation; revaluation vs devaluation

· Appreciation = a rise in currency value caused by market forces in a floating system.
· Depreciation = a fall in currency value caused by market forces in a floating system.
· Revaluation = an official increase in currency value in a fixed exchange rate system.
· Devaluation = an official decrease in currency value in a fixed exchange rate system.
· Common exam trap: do not use devaluation/revaluation for floating rates, and do not use appreciation/depreciation for official changes under fixed rates.

How exchange rates affect the economy

· Currency appreciation makes imports cheaper and exports more expensive for foreign buyers.
· Likely effects of appreciation:
· lower export demand
· higher import spending
· worse current account balance (or smaller surplus / bigger deficit)
· lower aggregate demand if net exports fall
· lower economic growth and possibly higher unemployment
· lower inflationary pressure because imported goods and imported inputs are cheaper
· mixed effect on living standards: consumers benefit from cheaper imports, but exporters/workers in export industries may lose.
· Currency depreciation makes exports cheaper and imports more expensive.
· Likely effects of depreciation:
· higher export demand
· lower import demand
· improved current account balance if demand is responsive enough
· higher aggregate demand if net exports rise
· higher economic growth and lower cyclical unemployment
· higher inflation because imports and imported inputs are more expensive
· possible fall in living standards if the cost of imported essentials rises.

AD/AS links you should use in exam answers

· Depreciation can increase net exports, so AD shifts right.
· This may increase real output/growth and reduce cyclical unemployment, but may also raise the price level.
· Appreciation can reduce net exports, so AD shifts left.
· This may reduce inflation, but also lower real output and raise unemployment.
· In evaluation, note that the size of the effect depends on price elasticity of demand for exports and imports, the state of the economy, and whether firms rely heavily on imported inputs.

An AD–AS diagram helps show the wider macroeconomic effects of exchange rate changes. In IB Economics, use it to explain how depreciation may raise AD, output, and inflation, while appreciation may reduce them. Source

Fixed exchange rates

· Under a fixed exchange rate, the government or central bank commits to a specific value or narrow band for the currency.
· To maintain the fixed rate, the central bank buys or sells foreign reserves and domestic currency.
· If there is upward pressure on the currency, the central bank may sell domestic currency / buy foreign currency to prevent it from rising.
· If there is downward pressure on the currency, the central bank may buy domestic currency / sell foreign currency reserves to prevent it from falling.
· This requires sufficient foreign exchange reserves.
· If the peg is officially lowered, this is devaluation.
· If the peg is officially raised, this is revaluation.

This diagram shows how a fixed exchange rate system is maintained using official intervention. It is useful for understanding how a central bank uses reserves to keep the currency at its target value. Source

Managed exchange rates

· A managed exchange rate (or dirty float) is mainly determined by the market, but the central bank intervenes at times to influence the value.
· Governments may want to avoid large swings in the exchange rate, protect export competitiveness, or reduce inflationary pressure.
· An overvalued currency is kept above its market equilibrium value.
· An undervalued currency is kept below its market equilibrium value.
· Overvaluation may reduce export competitiveness and cause current account problems.
· Undervaluation may help exports, but can make imports expensive and add to inflation.

Calculations and exam technique

· Be able to calculate the price of a good in another currency using the exchange rate given.
· Watch the quotation carefully: for example, $1 = ¥150</strong> is different from <strong>¥1 =$0.0067.
· To find the value of a currency from data, compare the old and new exchange rate and identify whether the currency has appreciated or depreciated.
· In data questions, always state which currency changed in value relative to which other currency.
· Show full working and do not lose marks through a simple inversion error.

Fast exam phrases

· An increase in demand for the currency causes an appreciation in a floating exchange rate system.
· A depreciation makes exports relatively cheaper and imports relatively more expensive.
· This may improve the current account balance, depending on how responsive demand is.
· A depreciation is likely to shift AD to the right via net exports, increasing output but also creating inflationary pressure.
· Under a fixed exchange rate, the central bank must intervene using foreign exchange reserves to maintain the peg.