A currency depreciates when its value falls relative to another currency under a floating exchange-rate system. This happens when demand for the currency decreases, supply of the currency increases, or both occur in the foreign exchange market.
For IB Economics, the essential task is to connect a real-world event, such as an interest-rate cut or rising imports, to a shift in currency demand or supply. This article provides currency depreciation explained through the foreign exchange model, with the terminology, diagrams, causal chains, and evaluation needed for exam answers.
What currency depreciation means
An exchange rate is the price of one currency expressed in terms of another. If EUR 1 initially buys USD 1.10 but later buys USD 1.00, the euro has depreciated against the US dollar because each euro now purchases fewer dollars.
Every exchange rate is relative. Saying that “the euro depreciated” is incomplete unless the other currency or a relevant currency index is identified. In the example above, the euro depreciated against the dollar while the dollar necessarily appreciated against the euro.
The direction of the numerical change depends on how the rate is quoted:
Exchange-rate quotationChangeInterpretationUSD per EUR1.10 to 1.00EUR depreciates against USDEUR per USD0.91 to 1.00USD appreciates against EUR
A reliable exam method is to translate the quotation into words. “USD 1.10 per EUR” means that one euro buys 1.10 dollars. If one euro later buys fewer dollars, the euro has lost value.
Depreciation is not devaluation
IB students must distinguish terminology according to the exchange-rate regime.
Currency movementFloating exchange rateFixed exchange rateMarket value fallsDepreciationNot normally called depreciation in the formal modelOfficial value is loweredNot applicableDevaluationMarket value risesAppreciationNot normally called appreciation in the formal modelOfficial value is raisedNot applicableRevaluation
The International Monetary Fund’s explanation of exchange-rate terminology confirms that depreciation and appreciation describe market-generated changes under floating rates, while devaluation and revaluation are official changes under fixed rates. A government policy may contribute to market depreciation, but that does not automatically make the change a devaluation.
Exchange rates are located in Unit 4: The global economy, specifically topic 4.5 Exchange rates, in the current published IB Economics course outline. The official IB Economics subject brief places exchange-rate analysis alongside international trade, the balance of payments, and development.
Why does a currency depreciate in the foreign exchange market?
Under a floating system, an exchange rate is determined by demand and supply. The Bank of England’s exchange-rate explainer describes the exchange rate as a price determined by people and institutions buying and selling currencies.
Suppose the market is for euros and the vertical axis is measured in USD per EUR:
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Demand for euros comes from people who must buy euros, including foreign purchasers of euro-area exports and foreign investors purchasing euro-denominated assets.
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Supply of euros comes from euro holders selling euros, including residents purchasing imports, travelling abroad, or acquiring foreign assets.
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The equilibrium exchange rate occurs where the quantity of euros demanded equals the quantity supplied.
The euro depreciates if:
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Demand for euros decreases, shifting the demand curve left.
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Supply of euros increases, shifting the supply curve right.
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Both changes occur simultaneously and create downward pressure on the euro’s price.
This is the central rule behind IB economics exchange rates:
Change in the forex marketEffect on the currencyDemand increasesAppreciationDemand decreasesDepreciationSupply increasesDepreciationSupply decreasesAppreciation
Currency supply in this model means the willingness of currency holders to sell that currency in the foreign exchange market. It is not automatically the same as the domestic money supply controlled or influenced by a central bank, although monetary policy can affect forex supply indirectly.
The broader RevisionDojo exchange rates notes cover floating, fixed, and managed exchange-rate systems. For a narrower review of the market mechanism, use the floating exchange rates topic hub.
Factors that reduce demand for a currency
Demand decreases when foreigners have less reason to acquire the currency. In a diagram, the demand curve shifts left from D1 to D2, reducing the equilibrium exchange rate from E1 to E2.
Falling demand for exports
Foreign consumers normally need the exporting country’s currency to purchase its goods and services. If demand for those exports falls, fewer units of the currency are demanded.
Export demand could fall because:
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Consumer incomes decline in important trading partners.
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Domestic products become less competitive because of relatively high inflation.
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Consumer preferences shift towards substitutes produced elsewhere.
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Trade barriers are imposed on the country’s exports.
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Prices of major commodity exports fall.
Commodity-exporting economies can be especially sensitive to changes in world prices. The Reserve Bank of Australia’s exchange-rate explainer identifies the terms of trade as an important influence on the Australian dollar. A decline in export prices relative to import prices can reduce export revenue and demand for the currency, contributing to depreciation.
Lower relative interest rates
Investors compare expected returns across countries. If a country’s interest rates fall relative to rates elsewhere, deposits and financial assets denominated in its currency may become less attractive.
The causal chain is:
Lower relative interest rates → weaker incentive to hold domestic assets → reduced capital inflow and possible capital outflow → lower demand and greater supply of the currency → depreciation.
Relative rates matter more than an isolated domestic rate. If two central banks reduce interest rates by similar amounts, the interest-rate differential may barely change. Investors also consider inflation, risk, taxation, liquidity, and their expectations of future currency movements, not just the headline policy rate.
Weaker inward investment
Foreign direct investment and portfolio investment normally require investors to acquire domestic currency. If political instability, weak growth prospects, regulatory uncertainty, or concerns about debt sustainability discourage investment, demand for the currency can fall.
The effect is not guaranteed because investors respond to expected risk-adjusted returns. A slowing economy might weaken investment demand, but investors could still purchase the currency if they regard the country’s government bonds as safe assets.
Expectations of future depreciation
Expectations can move exchange rates before the predicted economic event occurs. If traders expect a central bank to cut interest rates next month, they may sell the currency immediately rather than waiting for the official announcement.
This can become partly self-fulfilling:
Expected depreciation → traders sell the currency now → supply rises and demand falls → current depreciation.
However, expectations can reverse quickly. An announcement that is less severe than markets anticipated may cause a currency to appreciate, even if the announcement itself appears economically negative.
Factors that increase the supply of a currency
Supply increases when domestic currency holders want to exchange more of it for foreign currencies. In the forex diagram, supply shifts right from S1 to S2 and the equilibrium exchange rate falls.
Rising demand for imports
Residents supply their currency when purchasing foreign goods and services. If imports rise, more domestic currency is sold to obtain the currencies required for payment.
Imports may increase because:
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Domestic incomes and consumption rise.
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Foreign products become more attractive or competitive.
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Domestic firms depend heavily on imported energy, machinery, or components.
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Consumers travel abroad more frequently.
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Domestic productive capacity cannot meet rising demand.
The chain is:
Higher imports → greater demand for foreign currency → increased supply of domestic currency → depreciation.
A trade deficit can therefore place downward pressure on a currency, but the relationship is not mechanical. Large capital inflows can finance the deficit and create enough currency demand to offset the supply generated by imports.
Capital outflows
Residents and financial institutions sell domestic currency when purchasing foreign shares, bonds, businesses, property, or bank deposits. A rise in capital outflows therefore increases currency supply.
Capital outflows may follow lower relative interest rates, political uncertainty, expectations of depreciation, or improved investment opportunities overseas. This is the supply-side counterpart of falling foreign investment demand.
Central bank intervention
A central bank can place downward pressure on its currency by selling domestic currency and purchasing foreign currency. This directly increases the supply of domestic currency in the foreign exchange market.
Under a managed float, intervention may be used to moderate volatility or influence the exchange rate without establishing a permanently fixed value. The IMF explains that floating exchange rates remain mainly market determined, even though central banks may sometimes intervene.
How the main causes fit the demand and supply model
Some events affect one curve clearly, while others may influence both. In an exam, identify the most direct mechanism and explain it rather than listing every possible connection.
CausePrimary forex changeWhy the currency depreciatesFall in export demandDemand decreasesForeign buyers require less domestic currencyLower relative interest ratesDemand decreases and/or supply increasesCapital inflow weakens and residents may move funds abroadIncrease in importsSupply increasesResidents sell domestic currency to obtain foreign currencyGreater capital outflowSupply increasesDomestic investors purchase foreign assetsExpected depreciationDemand decreases and supply increasesTraders avoid buying and may sell the currencyPolitical or financial instabilityUsually demand decreases and supply increasesInvestors seek safer or more predictable assetsFall in commodity export pricesDemand decreasesExport revenue and currency receipts declineCentral bank sells domestic currencySupply increasesMore units are offered in the forex market
The RevisionDojo notes on changes in currency demand and supply can help you practise classifying events before drawing a diagram.
How inflation and economic growth affect depreciation
Relative inflation
Persistently higher inflation than in trading partners can make domestic goods relatively expensive. Foreign demand for exports may fall, reducing demand for the currency, while domestic consumers may switch towards imports, increasing its supply.
This gives the chain:
Higher relative inflation → weaker export competitiveness and stronger import demand → lower currency demand and higher currency supply → depreciation.
Do not write that inflation always causes immediate depreciation. Exchange rates are forward-looking, and a central bank may respond to inflation with higher interest rates. If investors expect those higher rates to generate attractive returns, short-run demand for the currency could rise even while inflation weakens its longer-run purchasing power.
Economic growth
Rapid domestic growth can increase imports because households and firms spend more, raising the supply of the currency. This can contribute to depreciation.
However, strong growth may also attract foreign direct investment and portfolio capital, increasing demand for the currency. The final outcome depends on whether the additional import-related supply or investment-related demand is stronger. This ambiguity is valuable evaluation in an IB response.
How to draw a currency depreciation diagram
A complete forex diagram should show the market for one named currency. For example, in the market for euros:
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Label the vertical axis exchange rate in USD per EUR.
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Label the horizontal axis quantity of EUR.
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Draw downward-sloping demand and upward-sloping supply.
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Mark the initial equilibrium E1 and exchange rate ER1.
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Shift demand left or supply right, depending on the stated cause.
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Mark the new equilibrium E2 and lower exchange rate ER2.
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State that the euro has depreciated against the dollar.
If US consumers buy fewer euro-area exports, shift demand for euros left. If euro-area consumers purchase more US imports, shift supply of euros right. Both changes lower the USD price of one euro, but the curves shift for different reasons.
A common mistake is shifting supply because “there is less demand.” Unless the event directly changes both curves, a fall in demand should be shown as a demand shift. The RevisionDojo guide to common exchange-rate mistakes explains how quotation errors and incorrect shifts weaken otherwise sound answers.
What happens after a currency depreciates?
Depreciation generally makes exports cheaper to foreign buyers and imports more expensive to domestic buyers, assuming prices are translated into buyers’ currencies. This may increase export volumes and reduce import volumes, improving net exports and aggregate demand.
The outcome is conditional rather than automatic:
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Demand for exports and imports may be price inelastic in the short run.
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Existing contracts can delay quantity changes.
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Firms may rely on imported components, raising their production costs.
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Exporters may lack spare capacity to increase output.
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Higher import prices may create cost-push inflation.
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Foreign-currency debt becomes more expensive in domestic-currency terms.
For this reason, avoid claiming that depreciation always corrects a current account deficit. The result depends on price elasticities, time, productive capacity, confidence, and the cause of the depreciation.
A strong IB Economics explanation
For a question asking why a currency depreciates, build a precise causal chain:
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Define depreciation in the context of a floating exchange rate.
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Identify the initial change, such as a fall in domestic interest rates.
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Name the forex curve affected and explain who buys or sells the currency.
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Show the curve shift and the lower equilibrium exchange rate.
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Apply the analysis to the currencies or country in the question.
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Qualify the result if the command term requires analysis or evaluation.
For example:
A reduction in Country A’s interest rate relative to rates abroad reduces the expected return on its financial assets. Foreign investors demand less of Currency A, while some domestic investors sell it to acquire higher-yielding foreign assets. Demand for Currency A decreases and its supply may increase. The equilibrium price of Currency A therefore falls in the foreign exchange market, meaning that it depreciates under the floating exchange-rate system.
Do not stop at “lower interest rates cause depreciation.” The marks usually come from explaining the intermediate links involving asset returns, capital flows, currency demand or supply, and equilibrium.
After reviewing the theory, attempt questions from the IB Economics exchange rates Questionbank. Use Jojo AI to check whether your response identifies the correct market, shifts the correct curve, and maintains a complete causal chain.
Conclusion
A currency depreciates under a floating exchange-rate system when demand for it falls, supply rises, or both changes occur. The underlying causes include weaker exports, higher imports, lower relative interest rates, capital outflows, changing expectations, political uncertainty, falling commodity prices, and central bank intervention.
For IB Economics, every explanation should move from the event to buyers or sellers, then to a curve shift and a lower equilibrium exchange rate. RevisionDojo’s exchange-rate notes, lessons, and Questionbank can help you practise this structure until it becomes automatic under exam conditions.
