IB Economics HLTopic 4 — The Global EconomyPaper 1, 2 & 3Core skill~12 min read
Causes and Consequences of Currency Movements
There is a long list of things that move an exchange rate, and trying to memorise it is a waste of an evening. Every single cause works through one of two channels: it either makes people want more of the currency, or it dumps more of the currency onto the market. Sort each cause into one of those two boxes and you never have to learn the list.
📚 What you need to know
Anything that raises demand for a currency causes an appreciation.
Anything that raises supply of a currency causes a depreciation.
Main causes: interest rates, inflation, FDI and portfolio flows, the current account, tastes, speculation, remittances, growth rates and central bank action.
A depreciation makes exports cheaper and imports dearer, so net exports and AD tend to rise.
Cheaper exports can raise growth and cut unemployment, but dearer imported inputs cause cost-push inflation.
An appreciation does all of that in reverse.
The only two questions that matter
When you meet a new cause, ask two things:
The sorting rule
Does this make foreigners want our currency? → demand rises → appreciation
Does this make us hand our currency over? → supply rises → depreciation
Foreigners need our currency to buy our exports and to invest here. We supply our currency when we buy imports or invest abroad. That is the whole mechanism.
The word “relative” is doing quiet work here. A 4% interest rate is high if everyone else offers 1%, and low if everyone else offers 7%.
The causes in detail
Cause
How it works
Effect on the currency
Relative interest rates
Higher rates here attract short-term deposits from abroad, known as hot money. Investors must buy our currency to get them.
Rate up means appreciation
Relative inflation rates
If our prices rise faster than everyone else’s, our exports look expensive, so foreigners buy fewer of them and need less of our currency.
Inflation up means depreciation
Net FDI
Foreign firms building factories here must buy our currency. Our firms building factories abroad must sell it.
Inflows appreciate, outflows depreciate
Net portfolio investment
Same logic for shares and bonds rather than factories.
Inflows appreciate, outflows depreciate
The current account
Exports must be paid for in our currency, imports in theirs. Rising net exports means rising demand for our money.
Net exports up means appreciation
Changes in tastes
If a country’s product suddenly becomes fashionable worldwide, buyers must acquire that country’s currency to pay for it.
Demand up means appreciation
Speculation
Most currency trading is speculative. Traders buy a currency they expect to rise, and that buying itself makes it rise.
Expectations become self-fulfilling
Remittances
Workers abroad sending money home convert foreign currency into the home currency.
Inflows appreciate
Relative growth rates
Fast-growing economies attract investment because returns look better there.
Faster growth means appreciation
Central bank action
Changing interest rates, quantitative easing, or directly buying and selling currency with reserves.
Depends on the direction of the policy
Speculation deserves a sentence of its own in any answer. It is the reason exchange rates can move sharply on nothing more than a rumour, and it is why fundamentals sometimes look like they are being ignored.
Consequences: what a depreciation does
Start with the two prices that change immediately.
Exports become cheaper in foreign currency, so foreigners buy more of them.
Imports become dearer in our currency, so we buy fewer of them.
Net exports are part of aggregate demand, so if net exports rise, AD shifts right.
There is a second inflation route this diagram does not show. Imported raw materials also cost more, which pushes SRAS left and raises prices further. That is cost-push inflation.
Two kinds of inflation from one depreciation. Demand-pull, because AD shifts right. Cost-push, because imported inputs get dearer. Mention both and you have covered the inflation part of any question completely.
Consequences across the economy
Indicator
Effect of a depreciation
Effect of an appreciation
Current account
Exports cheaper, imports dearer, so the balance tends to improve — but only if demand is elastic enough
Exports dearer, imports cheaper, so the balance tends to worsen
Economic growth
Higher net exports raise AD, so real GDP rises
Lower net exports reduce AD, so growth slows
Inflation
Rises, from both demand-pull and cost-push routes
Falls, as imported goods and inputs get cheaper
Unemployment
Falls, as export industries take on workers
Rises, as export industries lose orders
Living standards
Mixed — more jobs and wages, but dearer imports and less choice
Mixed — cheaper imports, but fewer export jobs
Living standards is the row students get wrong. Do not say a depreciation makes everyone poorer or richer. A factory worker in an exporting town gains; a family buying imported food loses. Name both and the mark is yours.
Worked examples
WORKED EXAMPLE 1
A country’s central bank raises interest rates from 2% to 5% while rates elsewhere stay at 2%. Using a diagram, explain the effect on its exchange rate. [4]
Step 1: who is affected
Foreign savers can now earn 5% instead of 2% by holding deposits in this country.
Step 2: what they must do first
To open those deposits they must buy the currency, so demand rises.
Step 3: on the diagram
The demand curve shifts right; the exchange rate rises from ER1 to ER2.
The currency appreciatessay “relative to other countries” — if everyone raised rates by 3% there would be no reason to move money at all
WORKED EXAMPLE 2
A country whose manufacturers rely heavily on imported components experiences a large depreciation. Discuss the likely effect on inflation. [6-style plan]
Route 1: demand-pull
Exports cheaper abroad, imports dearer at home, net exports rise, AD shifts right, price level rises.
Route 2: cost-push
Imported components now cost more in domestic currency, so firms’ costs rise, SRAS shifts left and prices rise again.
Why this country is hit harder
Heavy reliance on imported inputs means the cost-push effect is unusually strong.
Judgement
Inflation is very likely to rise, and by more than in an economy that sources inputs domestically.
Both routes point the same way here, so the effect is largeit also eats into the export gain, because those exports contain expensive imported parts
💡 Exam tip
Say relative every time you mention interest rates, inflation or growth. Money moves on differences, not levels.
For consequences, run through AD, inflation, unemployment, current account in that order. It keeps answers organised.
Remember the SRAS shift for imported inputs. Most answers only mention AD and miss half the inflation story.
Add a time dimension: exchange rate effects on trade take months to appear because contracts and habits take time to change.
For evaluation, the killer point is elasticity. If demand for exports is inelastic, a cheaper currency barely raises export volumes.
⚠ Common mix-up
Higher interest rates do not always strengthen a currency. If markets read the rise as panic about a weak economy, money can still leave.
Do not confuse the two inflation routes. Demand-pull moves AD; cost-push moves SRAS.
Depreciation does not automatically fix a trade deficit. It depends on elasticities, which is the next page but one.
Speculation is not irrational. Traders acting on expectations is a real economic cause, not just noise.
“Weak currency” is not the same as “weak economy”. Plenty of strong exporters prefer a weaker currency.
Up next: Fixed Versus Floating Exchange Rates — given everything above, which system should a country actually choose?
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