IB Economics Topic 4.5.1 Floating Exchange Rates Revision Notes (SL/HL)

IB Economics Topic 4.5.1 Floating Exchange Rates Revision Notes (SL/HL) | RevisionDojo

Written by official IB examiners

Definition

Exchange Rate

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

Each country has its own currency, and these currencies are not valid outside their own borders.
So, when country X wants to pay country Y, it cannot use its own currency directly.
Instead, it must go to the foreign exchange market, where it exchanges its currency for the currency of country Y, and then uses that currency to complete the payment.

Example

Imagine a group of friends from the USA planning a trip to France.
Since the currency in the USA is the US dollar, while in France the currency is the euro, they will need to exchange their dollars for euros in order to carry out transactions during their trip.

Tip

Think of it this way:

A demand for foreign currency creates a supply of domestic currency.
A demand for domestic currency creates a supply of foreign currency.

Determination of Floating Exchange Rate

Definition

Floating Exchange Rate

A floating exchange rate is a system in which the value of a currency is determined by supply and demand, without government intervention.

To get a better understanding of how market forces determine the floating exchange rates, we can look at the graphical representation of the exchange rates.

As we can see in the Diagram, there is a market for US dollars.
On the Y axis the price of USD in terms of euros and on the X axis the quantity of USD
In the equilibrium, the price of $1$ USD is equivalent to $e_2$ euro.
If the price of 1 USD suddenly became $e_3$ euros, as there would be a surplus of USD, as there would be more people willing to sell their dollars and buy euros
If the price of 1 USD became $e_1$ euro, there would be an excess demand for USD, as now people who had euros, would be willing to sell their euro and buy USD.

Note

As the price of USD expressed as euros increases, the quantity supplied of USD also increases.

A floating exchange rate diagram not only shows the price of dollars in terms of euros, but also the price of euros in terms of dollars.
When there are only two currencies in the market (dollars and euros):
1. The demand curve for dollars is also the supply curve for euros.
2. The supply curve for dollars is also the demand curve for euros.

Note

At the equilibrium exchange rate, the price of the currency is determined by the balance of demand and supply.

Appreciation & Depreciation

Appreciation

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Definition

Paywall

(on a website) an arrangement whereby access is restricted to users who have paid to subscribe to the site.

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Lorem ipsum dolor sit amet, consectetur adipiscing elit. Sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.

Duis aute irure dolor in reprehenderit

Duis aute irure dolor in reprehenderit in voluptate velit esse cillum dolore eu fugiat nulla pariatur. Excepteur sint occaecat cupidatat non proident, sunt in culpa qui officia deserunt mollit anim id est laborum.

Note

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Excepteur sint occaecat cupidatat non proident

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Tip

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Lorem ipsum dolor sit amet, consectetur adipiscing elit.
Sed do eiusmod tempor incididunt ut labore et dolore magna aliqua.
Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris.
Duis aute irure dolor in reprehenderit in voluptate velit esse cillum.

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Definition

Exchange Rate

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

Each country has its own currency, and these currencies are not valid outside their own borders.
So, when country X wants to pay country Y, it cannot use its own currency directly.
Instead, it must go to the foreign exchange market, where it exchanges its currency for the currency of country Y, and then uses that currency to complete the payment.

Example

Imagine a group of friends from the USA planning a trip to France.
Since the currency in the USA is the US dollar, while in France the currency is the euro, they will need to exchange their dollars for euros in order to carry out transactions during their trip.

Tip

Think of it this way:

A demand for foreign currency creates a supply of domestic currency.
A demand for domestic currency creates a supply of foreign currency.

Determination of Floating Exchange Rate

Definition

Floating Exchange Rate

A floating exchange rate is a system in which the value of a currency is determined by supply and demand, without government intervention.

To get a better understanding of how market forces determine the floating exchange rates, we can look at the graphical representation of the exchange rates.

As we can see in the Diagram, there is a market for US dollars.
On the Y axis the price of USD in terms of euros and on the X axis the quantity of USD
In the equilibrium, the price of $1$ USD is equivalent to $e_2$ euro.
If the price of 1 USD suddenly became $e_3$ euros, as there would be a surplus of USD, as there would be more people willing to sell their dollars and buy euros
If the price of 1 USD became $e_1$ euro, there would be an excess demand for USD, as now people who had euros, would be willing to sell their euro and buy USD.

Note

As the price of USD expressed as euros increases, the quantity supplied of USD also increases.

A floating exchange rate diagram not only shows the price of dollars in terms of euros, but also the price of euros in terms of dollars.
When there are only two currencies in the market (dollars and euros):
1. The demand curve for dollars is also the supply curve for euros.
2. The supply curve for dollars is also the demand curve for euros.

Note

At the equilibrium exchange rate, the price of the currency is determined by the balance of demand and supply.

Appreciation & Depreciation

Appreciation

Definition

Paywall

(on a website) an arrangement whereby access is restricted to users who have paid to subscribe to the site.

anim nostrud sit dolore minim proident quis fugiat velit et eiusmod nulla quis nulla mollit dolor sunt culpa aliqua

Duis aute irure dolor in reprehenderit

Note

Lorem ipsum dolor sit amet, consectetur adipiscing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam quis nostrud exercitation.

Excepteur sint occaecat cupidatat non proident

Tip

Lorem ipsum dolor sit amet, consectetur adipiscing elit.
Sed do eiusmod tempor incididunt ut labore et dolore magna aliqua.
Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris.
Duis aute irure dolor in reprehenderit in voluptate velit esse cillum.

1. Introduction to Economics2 subtopics

2. Microeconomics12 subtopics

3. Macroeconomics7 subtopics

4. The Global Economy10 subtopics

IB Economics 4.5.1 Floating Exchange Rates Notes

1. Introduction to Economics2 subtopics

2. Microeconomics12 subtopics

3. Macroeconomics7 subtopics

4. The Global Economy10 subtopics

Determination of Floating Exchange Rate

Appreciation & Depreciation

Appreciation

anim nostrud sit dolore minim proident quis fugiat velit et eiusmod nulla quis nulla mollit dolor sunt culpa aliqua

Duis aute irure dolor in reprehenderit

Excepteur sint occaecat cupidatat non proident

Unlock the rest of this chapter with a free account

Determination of Floating Exchange Rate

Appreciation & Depreciation

Appreciation

anim nostrud sit dolore minim proident quis fugiat velit et eiusmod nulla quis nulla mollit dolor sunt culpa aliqua

Duis aute irure dolor in reprehenderit

Excepteur sint occaecat cupidatat non proident

Unlock the rest of this chapter with a free account