IB Economics Exchange Rates

Exchange Rates: When Currencies Go Dancing - IB Economics

Target Question:

What is a floating exchange rate and what factors cause currencies to appreciate or depreciate?

The Most Embarrassing Queue in the Airport

It's holiday time soon so let's imagine for a second you're standing in the currency exchange queue at the airport. You hand over your £200 to the person behind the counter, and they hand you back... less than you expected. You do the maths in your head, look confused, do it again, and then just accept the situation and walk away slightly poorer than you originally were.

Today we are dealing with the foreign exchange market. Applies to: everyone who's ever been on holiday abroad, bought something from a US website, or watched the news one morning and heard a reporter say "the pound fell today."

The exchange rate you just got was determined by millions of buyers and sellers, trading currencies every single second of every single day. The foreign exchange market (or forex market, if you want to sound like you work in the City of London) is the largest financial market in the world. Basically over $7 trillion traded per day. Your holiday money is, quite, a drop in the ocean comparing to the million transactions taking place on a daily basis.

So how does everything work? Let's find out.

What Is an Exchange Rate?

An exchange rate:

An exchange rate defines the value of one currency in relation to another currency or a basket of currencies.

In plain English: it tells you how many units of one currency you get for one unit of another. If the exchange rate between the British pound and the US dollar is 1.27, it means £1 buys you $1.27.

But that number is not fixed. It changes. Constantly. And the way it changes depends on which type of exchange rate system a country uses.

The Floating Exchange Rate: Let the Market Decide

A floating exchange rate:

A floating exchange rate is one where a currency's value is determined entirely by the forces of demand and supply in the foreign exchange market, without direct government intervention.

For instance you have the pound, the dollar, the euro - they're all out there hustling, and their "worth" at any given moment is whatever the market decides it is.

Most major economies - the UK, the US, the Eurozone, Australia, Canada - operate floating exchange rate systems.

The Forex Market: How Does it Work?

In the forex market, currencies are bought and sold in pairs. If a French company wants to buy American goods, it needs US dollars. To get dollars, it sells euros. This is the first fundamental mechanic you need to learn: to buy a foreign currency, you must first sell your own.

In a diagram of the exchange market, the exchange rate sits on the Y-axis (priced in a foreign currency, say euros), while the quantity of the domestic currency (say, US dollars) sits on the X-axis. The demand curve represents people wanting to buy that currency, and the supply curve represents people wanting to sell it. Where they meet gives you the equilibrium exchange rate (PE) and equilibrium quantity (QE).

Exchange market equilibrium for US dollars priced in euros - standard supply and demand diagram with PE and QE marked. Source: IB Economics Diagrams

Appreciation vs Depreciation

When currencies "go dancing," the title I have chosen for this entry, they're really doing one of two things: going up or going down in value. In the world of floating exchange rates, these moves have specific names.

Currency appreciation:

Currency appreciation is an increase in the value of one currency relative to another within a floating exchange rate system, caused by an increase in demand for or a decrease in supply of that currency.

Currency depreciation:

Currency depreciation is a decrease in the value of one currency relative to another within a floating exchange rate system, caused by a decrease in demand for or an increase in supply of that currency.

Imagine currency are dance partners, crucially - if one currency appreciates, the other must depreciate. You can't have one go up without the other going down. If the US dollar strengthens against the euro, then by definition, the euro has weakened against the dollar. They move and dance together, always.

So, if one currency appreciates against another, the second currency must depreciate by an equivalent amount - the two currencies always move in opposite directions relative to each other.

Appreciation of the US Dollar - Example

Imagine consumers across Europe suddenly start buying a lot of American products. Netflix subscriptions, iPhones, Tesla cars, Nike trainers - whatever. European buyers need to purchase US dollars to pay for these things. This increases the demand for USD in the forex market (D shifts from D1 to D2), and simultaneously increases the supply of euros as European buyers exchange their euros for dollars (S of euros shifts from S1 to S2). After all the transactions the dollar appreciates. Its price in euros goes up.

Appreciation of the USD - demand for USD shifts right from D1 to D2, price of USD in EUR rises from PE1 to PE2. Source visit: IB Economics Diagrams

Depreciation of the US Dollar - Example

American consumers suddenly become obsessed with European things - German cars, Italian espresso machines, Belgian biscuits, French wine (they've finally developed taste). American buyers need to sell their dollars and buy euros. This increases the supply of USD in the market (S shifts from S1 to S2), while increasing the demand for euros. The dollar depreciates. Its price in euros falls.

Depreciation of the USD - supply of USD shifts right from S1 to S2, price of USD in EUR falls from PE1 to PE2. Source visit: IB Economics Diagrams

Remember: a dollar depreciation = a euro appreciation. Same dance, but different outcome.

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What Actually Moves a Currency? The Ten Factors

So currencies go up and down - but why? What causes the demand and supply of a currency to shift in the first place? There are ten key factors, and they're all worth knowing for your IB Economics exam.

1. Foreign Demand for Exports

When the rest of the world wants to buy a country's goods and services, they need to acquire that country's currency first (foreign currencies aren't accepted as legal tender abroad). So when demand for UK exports rises - say, Scottish whisky becomes popular in Japan - Japanese buyers flood into the forex market buying pounds. Demand for GBP rises, the pound appreciates.

If UK exports fall out of favour (maybe our reputation for food takes a hit), demand for pounds drops and the currency can depreciate. That's how the market works.

2. Domestic Demand for Imports

When you - or your country's businesses - buy foreign goods, you need foreign currency. You sell your own currency to get it. This increases the supply of your domestic currency on the forex market, which pushes its value down. More imports = more supply of your currency = depreciation potential. That's why a country running a massive trade deficit (buying far more than it sells) often sees downward pressure on its currency.

3. Inward and Outward Foreign Direct Investment (FDI)

FDI is when multinational companies invest in physical operations abroad - building factories, opening offices, acquiring local businesses.

• Inward FDI (foreign companies investing in your country) means they need to buy your currency to pay for land, labour, materials. This boosts demand for your currency → appreciation.

• Outward FDI (your companies investing abroad) means they need to buy foreign currency. They sell your domestic currency to do so → depreciation.

IB Economics Real-life example: when Samsung announced a $17 billion semiconductor plant in Texas in 2021, it needed to convert South Korean won into US dollars. That's outward FDI from South Korea's perspective - downward pressure on the won, upward on the dollar.

4. Inward and Outward Portfolio Investment

Portfolio investment is buying financial assets abroad - stocks, shares, government bonds - rather than physical operations.

• Inward portfolio investment: foreign investors buy your country's bonds or shares. They convert their currency into yours → demand for your currency rises → appreciation.

• Outward portfolio investment: your investors buy foreign assets. They sell your currency → depreciation.

IB Economics Real-life example: When the US Federal Reserve raises interest rates, global investors rush to buy US government bonds (attractive yield). They all need dollars to do that. The result? The dollar strengthens. This is exactly what happened in 2022–2023 as the Fed hiked aggressively - the dollar surged to a 20-year high against a basket of currencies.

5. Remittances

Remittances are money sent home by workers living abroad. A Filipino nurse working in London sends £500 back to her family in Manila every month. To do that, she converts pounds into Philippine pesos.

This increases the supply of GBP and increases demand for PHP - slightly weakening the pound and strengthening the peso, all else equal.

IB Economics Real-life example: Globally, remittances are enormous. India received over $120 billion in remittances in 2023 - the highest of any country in the world. Mexico, China, and the Philippines follow closely. For many developing economies, remittances are a critical source of foreign currency and income support.

6. Speculation

Currency speculators are basically betting on which way a currency will move in the short-term. If traders think the pound is about to rise, they buy pounds now hoping to sell them later at a profit. This buying itself pushes the pound up. If they think it'll fall, they sell - driving it down.

IB Economics Real-life example: The most famous example in history? September 1992, when billionaire investor George Soros bet against the British pound and shorted it so aggressively that the UK was forced to withdraw from the European Exchange Rate Mechanism. He made over a billion dollars in a single day. The British press called it "Black Wednesday." Soros called it a very good Wednesday.

Speculation can cause massive short-term volatility in exchange rates - completely detached from economic fundamentals.

7. Relative Inflation Rates

Inflation is a currency's worst enemy. When a country has higher inflation than its trading partners, its goods become relatively more expensive. Foreign buyers want less of them. Demand for the currency falls → depreciation.

IB Economics Real-life example: Turkey is a good example. In 2022, Turkey's inflation rate hit over 80% - one of the highest in the world. The Turkish lira absolutely collapsed, losing roughly 80% of its value against the dollar over a few years. When your money buys less stuff at home, it buys less stuff everywhere.

8. Relative Interest Rates

Interest rates are the return on savings and the cost of borrowing. When a country raises interest rates, it becomes more attractive to international investors and savers - they can earn more on deposits. They rush to buy that currency to invest there.

Higher interest rates → more demand for the currency → appreciation. Lower interest rates → less demand → depreciation.

This is why forex traders watch central bank meetings so carefully. When the Bank of England raises rates, the pound often ticks up almost immediately. Markets are forward-looking - they're constantly trying to guess what central banks will do next.

9. Relative Economic Growth Rates

When an economy is growing strongly - real GDP rising, consumer confidence high, businesses investing - it tends to attract foreign investment. Strong growth signals stability and positive investment returns. Additionally, as growth accelerates, central banks often raise interest rates to prevent overheating (see factor 8 above), which further attracts capital.

Strong growth → more inward investment → more demand for the currency → appreciation.

IB Economics Real-life example: When the UK economy outperformed European peers in the mid-2010s, the pound held up relatively well. When growth disappoints - as it did during the post-financial crisis years - currency downwards pressure tends to follow.

10. Central Bank Intervention

Even in a "floating" system, central banks aren't completely hands-off. They can:

• Buy or sell their own currency directly in the forex market to influence its value

• Adjust interest rates (which indirectly affect currency demand - see factor 8)

• Limit the supply or sale of their currency to prevent manipulation by foreign governments or large investors

IB Economics Real-life example: The Swiss National Bank is famous for this. Switzerland's economy is so small and so tied to exports that an excessively strong franc crushes Swiss exporters. For years, the SNB actively sold francs and bought foreign currencies to keep the franc from appreciating too sharply.

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What Is a Managed Float?

Not every country leaves its currency completely to the market. A managed floating exchange rate:

A managed floating exchange rate - also called a dirty float - is a system in which a currency's value is primarily determined by market forces but the central bank intervenes periodically to prevent excessive volatility or to keep the exchange rate within a target range.

The best example in the world? China.

China's central bank (the People's Bank of China) sets a daily reference rate for the renminbi (RMB) each morning. The currency is then allowed to trade no more than 2% above or below that reference rate on any given day in onshore markets. This creates a corridor - a managed band - that gives China the flexibility of a float while maintaining significant control.

Why does China do this? Because extreme currency movements could devastate its export-dependent economy. A rapid appreciation of the RMB would make Chinese goods more expensive overnight. A rapid depreciation could trigger capital flight and inflation. The managed float is a political and economic safety net.

Critics - particularly in the US - have long accused China of deliberately undervaluing the RMB to keep its exports cheap. It's been a source of trade tension for decades. But China's system is legal and increasingly common. Several emerging market economies operate similar systems.

When the Exchange Rate Moves, the Whole Economy Feels The Effect

Alright - we've covered what exchange rates are and what moves them. But, when a currency appreciates or depreciates, what happens to the whole of the economy?

There are five key areas that your IB Economics syllabus expects you to understand.

Impact 1: Inflation

Exchange rate movements affect inflation through two routes.

Route A: Demand-pull inflation via depreciation

When a currency depreciates, exports get cheaper for foreign buyers (great!) and imports get more expensive for domestic buyers (not so great). So what would be the net effect? Exports rise, imports fall, and net exports (X – M) increase. This boosts aggregate demand (AD), shifting the AD curve rightward in the AD/AS model.

In your diagram: AD shifts from AD1 to AD2. Real GDP rises from Y1 towards YF (full employment), but the price level also rises from PL1 to PL2. That's demand-pull inflation - driven by the surge in net exports.

AD/AS model showing rightward shift in AD following currency depreciation - rising real GDP and rising price level. Source visit: IB Economics Diagrams

Currency depreciation can cause both demand-pull inflation (via higher net exports boosting aggregate demand) and cost-push inflation (via higher import costs raising firms' production costs).

Route B: Cost-push inflation via depreciation

When a currency depreciates, imported goods become more expensive - including raw materials and components that domestic firms rely on to produce things.

For a country like the UK usually importing a huge amount of its energy, food, and industrial inputs, this is incredibly relevant. When input costs rise, the Short-Run Aggregate Supply (SRAS) curve shifts leftward (from SRAS1 to SRAS2). The price level rises from PL1 to PL2 (inflation) but real GDP falls from Y1 to Y2. This is typical cost-push inflation - stagflation territory.

AD/AS model showing leftward shift in SRAS following currency depreciation - rising price level and falling real GDP. Source visit: IB Economics Diagrams

IB Economics Real-life example: This is exactly what happened in the UK following the Brexit vote in 2016. The pound fell roughly 15–20% against a basket of currencies. UK inflation subsequently rose - not just because of demand, but because the cost of imported goods (food, fuel, consumer electronics) surged. British consumers noticed it at the supermarket. Some called it the "Brexit tax."

What about appreciation? Currency appreciation has the opposite effect. Export prices rise (making UK goods less competitive abroad), import prices fall (good for consumers, good for keeping inflation low). The fall in net exports reduces aggregate demand, shifting the AD curve leftward from AD1 to AD2. Real GDP falls from Y1 to Y2, and the general price level falls from PL1 to PL2 - downward pressure on inflation.

AD/AS model showing leftward shift in AD following currency appreciation - falling real GDP and falling price level. Source visit: IB Economics Diagrams

But while lower inflation sounds good, falling AD means lower growth - there are always trade-offs.

Impact 2: Economic Growth

This follows logically from the inflation section.

When a currency appreciates:

• Exports become more expensive → foreign demand for exports falls

• Net exports (X – M) decline

• AD falls (leftward shift in the AD curve)

• Real GDP falls

This is bad news for growth. Export-reliant economies are particularly vulnerable. Japan's economy has long wrestled with this tension - the yen strengthened dramatically in the early 2010s, crushing Japanese exporters. The Japanese government eventually engineered a massive depreciation campaign ("Abenomics") in order to reverse this situation.

When a currency depreciates:

• Exports become cheaper → foreign demand rises

• Net exports increase

• AD rises → real GDP increases

However, how much growth actually improves depends heavily on how much the country relies on imported inputs for production. If your factories need imported components to make stuff, a depreciation simultaneously boosts export demand and raises your production costs. The net effect on growth is more ambiguous than any IB Economics textbook diagram might suggest.

Impact 3: Unemployment

Exchange rates and jobs are directly linked through the export sector.

When a currency appreciates, exports become more expensive. Foreign buyers switch to cheaper alternatives. Demand for domestically produced goods falls. Firms see revenues drop. They cut production, lay off workers.

Industries most exposed? Tourism, manufacturing, agriculture - anywhere that sells to international markets heavily.

IB Economics Real-life example: After Japan's yen strengthened in 2011 following the earthquake and tsunami, Japanese manufacturers like Toyota and Sony relocated production abroad to escape the unfavourable exchange rate. Jobs left Japan. When the yen later depreciated under Abenomics, some of that production returned.

The reverse situation is also true: a depreciation boosts export demand, firms ramp up production, and employment rises - particularly in export-oriented sectors.

Impact 4: The Current Account Balance

The current account tracks a country's trade in goods and services with the rest of the world, plus net income from overseas investments and transfers.

A currency depreciation tends to improve the current account (assuming demand is responsive to price changes):

• Exports become cheaper → export volumes rise

• Imports become more expensive → import volumes fall

• Net exports (X – M) improve → current account improves

A currency appreciation tends to worsen it:

• Exports more expensive → export volumes fall

• Imports cheaper → import volumes rise

• Current account deteriorates

However, your IB Economics teacher should love this caveat, the improvement from depreciation isn't instant by any means. In the short run, import costs rise faster than export volumes adjust. The current account can actually worsen before it gets better. Economists call this the J-curve effect (though it's not required for this unit, it's great background knowledge).

The UK has run a persistent current account deficit for decades. Post-Brexit pound depreciation was expected to help fix this by making exports more competitive. It helped a little. But structural trade deficits are stubbornly resistant to exchange rate fixes alone.

Impact 5: Living Standards

A strong currency sounds great - your money goes further abroad, imports are cheap, inflation is low. But it makes exporters uncompetitive, can cause job losses in manufacturing and tourism, and diminishes overall economic growth. For workers in export industries, a strong pound isn't a gift - it's a threat.

A weak currency boosts exporters and can stimulate growth and jobs. But it makes everything imported more expensive. Petrol, food, electronics, clothing - most of which relies on some imported input - gets pricier. For households on tight budgets, currency depreciation squeezes real purchasing power. Living standards fall in real terms even if employment is holding up.

For the world's least developed countries (LDCs), currency depreciation is particularly lethal. Many rely on importing essential goods - food, medicines, machinery for development - that they cannot produce domestically. When their currency falls, accessing these necessities becomes harder and more expensive. Debt repayments on US dollar-denominated loans also become costlier. Exchange rate weakness can trap developing economies in a vicious cycle of rising costs, falling living standards, and reduced capacity for growth.

IB Economics Real-life example: Argentina is the modern example. Years of peso depreciation, inflation spiralling beyond 200% annually in 2023, and ordinary Argentinians watching their wages evaporate in real terms - the human cost of currency confusion is real and devastating.

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IB Economics Summary

Every time you buy something online from the US, check the price of a foreign holiday, fill up your car, or watch the news and hear about a central bank decision - something to do with exchange rates is affecting the context.

For IB Economics, the floating exchange rate is basic to understanding how open economies interact. Exports, imports, inflation, employment, investment - they're all connected through currency. Learn to think in terms of demand and supply for currencies, and the rest of international economics starts to make sense.

Frequently Asked Questions: Floating Exchange Rates

Q1: What is a floating exchange rate in IB Economics? A floating exchange rate is a system in which a currency's value is determined by market forces - the demand and supply for that currency in the foreign exchange market - without direct government control. Most major economies, including the UK and US, operate floating exchange rate systems.

Q2: What causes a currency to appreciate? A currency appreciates when demand for it rises or supply of it falls in the forex market. Common causes include increased foreign demand for exports, higher domestic interest rates (attracting portfolio investment), strong economic growth, and inward foreign direct investment.

Q3: What is the difference between appreciation and depreciation? Appreciation means a currency's value has increased relative to another - it buys more foreign currency than before. Depreciation means its value has fallen - it buys less. In a floating exchange rate system, if currency A appreciates against currency B, then B has depreciated against A by definition.

Q4: What is a managed float (dirty float)? A managed float is a hybrid exchange rate system where the currency broadly floats with market forces, but the central bank intervenes to prevent excessive fluctuation. China's renminbi is the most prominent example - the People's Bank of China sets a daily reference rate and allows the currency to move no more than 2% either side of it.

Q5: How do exchange rate changes affect inflation? Currency depreciation can raise inflation through two routes: (1) demand-pull inflation, as cheaper exports boost net exports and increase aggregate demand; and (2) cost-push inflation, as more expensive imports raise firms' production costs and shift the short-run aggregate supply curve leftward. Currency appreciation generally has the opposite effect, reducing inflationary pressure.

Stay well,

Related Topics:

IB Economics Hub Page your IB Economics daily guide

IB Economics The Global Economy Hub Page access Exchange Rates here as well as the rest of the module 4

IB Economics Activity book Page Module 4 The Global Economy Unit 4.7 for Exchange Rates exam practice, activities, model answers and IB Economics Marking schemes

IB Economics the current account and balance of payments Page, revise this topic as it has a direct relationship with exchange rates

IB Economics Diagrams Page Check Unit 27 for All Exchange Rates diagrams with explanations

IB Economics Fiscal Policy Hub Page and Monetary Policy Hub Page for discussing central bank intervention and interest rates, both topics with a direct relationship with exchange rates

IB Economics Economic growth and the business cycle → for discussing economic growth effects of appreciation / depreciation

IB economics Calculations Book make sure you check unit 24 for Exchange Rates calculations exercises, IB model answers, and IB marking schemes

IB Economics Unemployment Hub Page → for discussing job losses from appreciation

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