Revise Exchange rates for IB Economics (4.4)

An exchange rate is the price of one currency expressed in terms of another. Written as £1 = $1.25, it tells you that one pound trades for 1.25 US dollars. Read the other way, one dollar trades for 1 ÷ 1.25 = $0.80 worth of a pound (80 pence). Because it is a price, an exchange rate always has two sides: whenever the pound is worth more dollars, the dollar is automatically worth fewer pounds. Getting the direction right is half the battle in every Paper 3 question on this topic.

In a floating system the exchange rate is set exactly like any price in a competitive market - where the demand for the currency meets the supply of it. Consider the market for pounds, with the price of pounds in dollars ($/£) on the vertical axis and the quantity of pounds on the horizontal axis. Demand for pounds comes from anyone who needs pounds: foreigners buying UK exports, foreigners investing in UK assets, and speculators betting the pound will rise. Supply of pounds comes from anyone selling pounds for another currency: UK residents buying imports, UK residents investing abroad, and speculators betting the pound will fall. The equilibrium rate is where the quantity of pounds demanded equals the quantity supplied.

An appreciation is a rise in the currency's value: the pound moves from £1 = $1.25 to, say, £1 = $1.40, so each pound now buys more dollars. It is caused by an increase in demand for the currency (the demand curve shifts right) or a decrease in its supply (the supply curve shifts left). A depreciation is the opposite - a fall in value, say £1 = $1.25 to £1 = $1.10 - caused by falling demand or rising supply. Keep the vocabulary precise: in a floating system market forces produce appreciation and depreciation, whereas a deliberate official change to a pegged rate is a revaluation (up) or devaluation (down).

Paper 3 rewards clean, correct conversions. The safe rule is to read the quote literally. With £1 = $1.25 the rate is 'dollars per pound', so to turn a pound price INTO dollars you MULTIPLY by 1.25, and to turn a dollar price back INTO pounds you DIVIDE by 1.25. Do a common-sense check afterwards: because a pound is worth more than a dollar here, a price should have a bigger number in dollars than in pounds. If your answer fails that check, you have multiplied where you should have divided.

Because the exchange rate connects domestic prices to world prices, a change in it ripples through the whole economy. The clearest way to remember the trade effects is SPICED - a Strong Pound means Imports Cheaper, Exports Dearer (a weak pound reverses each). From those two facts everything else follows: the current account, inflation and growth all respond to how export and import prices, and therefore quantities and values, change.

None of these effects is automatic or one-directional in welfare terms. A depreciation may boost exports and growth but stoke inflation and hurt import-dependent firms; an appreciation may tame inflation and lift consumers' purchasing power but damage exporters. The exam-strong answer states the effect AND the condition or trade-off, rather than asserting that a weak currency is simply 'good' or a strong currency simply 'bad'.

Not every currency floats freely. Under a fixed exchange rate the authorities peg the currency to another currency, a basket, or a commodity, and the central bank intervenes to hold that peg: it buys its own currency with foreign-currency reserves (and may raise interest rates) to prevent a fall, or sells its own currency to prevent a rise. Under a managed float the rate is mostly market-determined, but the central bank steps in occasionally to smooth excessive volatility or to steer the rate towards a preferred level. Fixed systems offer certainty and can anchor inflation, but they cost reserves and surrender independent monetary policy; floating systems give policy freedom and adjust automatically, but can be volatile.

Exchange rates are the hinge between a country and the rest of the world, so this topic connects directly to the balance of payments (4.5) and to exchange-rate and expenditure-switching policies used to correct current-account imbalances. The same numerical discipline you practised here - convert carefully, show method, judge the effect with its condition - is exactly what Paper 3 tests across the global-economy unit.