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Exchange rates
Syllabus point: 3.2.

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This week in IB Economics:
1. Determination of freely floating exchange rates
2. Causes of changes in the exchange rate

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3. The effects of exchange rate changes

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Determination of exchange
rates
Lesson’s objective:
1. Explain that the value of an exchange rate in a floating system

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is determined by the demand for, and supply of, a currency.
2. Draw a diagram to show determination of exchange rates in a
floating exchange rate system.

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Definition of exchange rate
An exchange rate is the value of one
currency expressed in terms of another

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currency.

• For example, €1=US$1.10.

This means that one euro may be
exchanged for 1.10 US dollars
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Floating exchange rates
• A floating exchange rate is one where the value
of a currency is determined by the demand for

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and supply of that currency on the foreign
market.

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So how do you think we draw
the diagram?

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Imagine the market for
Euros in the United States
of America

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Floating exchange rates

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• Those demanding dollars are presumably holding euros and
seeking to purchase dollars, whereas
• the suppliers of dollars are holding dollars and are willing to 8
exchange them for euros.
Your task – be a thinker

• Student workpoint 23.3.

• Using the data in Figure 23.4,

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explain how the value of the
Canadian dollar has changed
in terms of Euros and how
the euro has changed in
terms of Canadian dollars for
the time period shown. Look
carefully at the labels on the
axes. What can you say about
the relationship between the
two graphs?

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Difference between
appreciation and depreciation

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• Appreciation is an increase in the free
market value of a currency
• Depreciation is a decrease in the free
market value of a currency

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Appreciation
• Appreciation is an increase in the free market value of a
currency

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Depreciation
• Depreciation is a decrease in the free market exchange of a
currency

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 Your task…

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a) Define the term appreciation indicated in bold in the text.
(2 marks)
b) Using an appropriate diagram, analyse the effect of “foreign buying of
shares in South African companies” on the value of the rand.
(4 marks)
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ECONOMICS STANDARD LEVEL PAPER 2 2013
 … and the answer
a) Appreciation ‐ a rise in the value of a currency.
• Comment [A1]: Vague definition. 1 mark.
• An increase in the price of one currency in terms of another

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under a floating exchange rate system.
Correct diagram and an accurate written
b) G response.
For drawing a clearly labelled foreign
exchange market diagram showing an
increased demand for the rand, causing
the equilibrium exchange rate to
increase and an explanation that
foreigners buying shares in South
African companies will purchase rand
in order to purchase the South African
shares, causing an increased demand 14
for rand and thus an appreciation of
the currency.
Plenary
• What did I want you to learn today?
• What could I use this knowledge for?

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Causes of changes in

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the exchange rate

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This week in IB Economics:
1. Determination of freely floating exchange rates
2. Causes of changes in the exchange rate

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3. The effects of exchange rate changes

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Lesson’s objective
• Describe the factors that lead to changes in currency demand
and supply, including:

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1. Domestic demand for imports,
2. Foreign demand for a country’s exports,
3. Relative interest rates,
4. Relative inflation rates,
5. Investment from overseas in a country’s firms
6. Speculation.

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Determinants of exchange
rates
• Demand for goods and services

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When demand for a country’s exports
increases, it increases demand for
the currency itself. To buy the
exports, the importers first need to
buy the exporting country’s currency
to pay for them.

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Determinants of exchange
rates
• Demand for foreign direct investment

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To make any kind of FDI by e.g.
starting a new firm or opening a new
branch location, requires that
country’s currency to buy e.g. capital
equipment or materials. So an
increase in FDI appreciates a
currency, and the loss of FDI
depreciates it.
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Determinants of exchange
rates
• Relative interest rates

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Should the i/r offered to depositors
increase, individuals and banks
would be attracted to the higher
relative interest rate and buy the
local currency to deposit in the bank.
(aka capital inflow)

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Determinants of exchange
rates
• Relative inflation rates

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Higher inflation tends to
depreciate a currency,
and lower relative
inflation tends to
appreciate it.

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Determinants of exchange
rates
• Speculation Speculators may buy a currency

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hoping it will appreciate, and sell it
when they believe it has reached
peak value.

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Your task
• http://www.contentextra.com/bacconline/bacContentFiles/Economi
cFiles/Worksheets-PDF/Worksheet221ExchangeRateDeterminants.p

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df

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This week in IB Economics:
1. Determination of freely floating exchange rates
2. Causes of changes in the exchange rate

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3. The effects of exchange rate changes

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Lesson’s objectives
• Evaluate the possible economic consequences of a change in
the value of a currency.

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• Inflation rate
• Employment
• Economic growth
• Current account balance

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Your task…
• In groups, discuss the effects that an
appreciation/depreciation of a currency will have on the major

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macroeconomic goals.

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Appreciation
Advantages Disadvantages

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• Less expensive imports • Export levels reduced
• Lower costs of production • Now goods and services
• Improve living standards are more expensive in
• Vital for developing terms of other currencies
countries! • Greater imports hurt
• Reduce inflation domestic production
• Competitive pressure on • Might result in lower
domestic exporters economic activity.
• Loss of international f a n y evaluation
Can you t hin k o
competitiveness a ll the s e sta te ments?
points for 30
• Solution: find ways to
reduce costs and innovate!
Depreciation
Advantages Disadvantages

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• Expansion of domestic • Imported inflation
industries • Persistent source of
• Increase in exports inflation (if country relies
• Increase in employment heavily on imports and PED
is relatively inelastic)
• Domestic products seem
cheaper

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