IB Economics HLTopic 4 — The Global EconomyPaper 1, 2 & 3Core idea~10 min read
Exchange Rates and the Balance of Payments
These two topics are really one topic. The exchange rate changes what a country’s trade is worth, and a country’s trade changes the exchange rate. The loop runs in both directions at once, which is why questions on it feel slippery until you draw the chain out properly.
📚 What you need to know
A weaker currency makes exports cheaper abroad and imports dearer at home.
That should improve the current account balance — but only if buyers respond enough.
A stronger currency does the reverse and tends to worsen the current account.
The size of the effect depends on the price elasticity of demand for exports and imports.
Money moving in the financial account also moves the exchange rate: inflows raise demand for the currency.
A stronger currency makes a country a more expensive place to invest in, which can cut inflows.
Why the two are joined at the hip
The current account records the value of a country’s trade. The exchange rate sets the price of that country’s money. Change the price of the money and you change the value of every trade.
It works the other way too. Every export sale creates demand for the exporter’s currency, because the buyer must acquire it to pay. Every import purchase supplies the importer’s currency to the market.
The loop
exchange rate → price of exports and imports → current account
current account → demand for and supply of the currency → exchange rate
What a depreciation does to the current account
The red line is where the marks are. Everything above it is automatic; the last step is a prediction that may not come true.
Notice something important about the middle row. Export prices change on the day the exchange rate moves. Export volumes change only when a foreign buyer decides to switch supplier, which might take a year of contracts running out.
What an appreciation does
The same chain, reversed at every step.
Exports become more expensive for foreign buyers, so export volumes fall.
Imports become cheaper at home, so import volumes rise.
Net exports fall, so the current account balance worsens.
There is a silver lining. Cheaper imports mean cheaper raw materials for domestic manufacturers and cheaper goods in the shops, which pushes inflation down.
The catch: it all depends on elasticity
A depreciation cuts the foreign price of exports. Whether that raises export revenue depends on how much extra buyers actually buy.
This is the idea the Marshall-Lerner condition turns into a rule. We put a number on it two pages from now.
Where elasticity comes from. Exports face elastic demand when there are close substitutes from other countries. They face inelastic demand when the product is essential, unique, or sold under long-term contracts — which is common for commodities like oil and minerals.
The financial account works on the exchange rate too
The current account is not the only thing moving currencies. Investment flows are far larger day to day.
A firm from abroad investing here must buy the local currency first, so demand rises and the currency appreciates.
Domestic investors sending money overseas supply the local currency, so it depreciates.
And the causation runs backwards again. A strong currency makes a country’s assets expensive for foreign investors, so it can put them off. A weaker currency makes the same factory or shareholding look like a bargain, which attracts inflows.
This is a neat self-limiting loop worth mentioning in an essay: a currency that appreciates too far starts to discourage the very investment inflows that were pushing it up.
Worked examples
WORKED EXAMPLE 1
A country’s currency depreciates by 15%. Explain two reasons why its current account deficit might not improve in the following year. [4]
Reason 1: inelastic demand
If its exports are commodities with few buyers, a lower price brings little extra volume, so export revenue barely moves.
meanwhile imports cost more in domestic currency, so import spending actually risesReason 2: time lags
Existing contracts still run at old volumes, and buyers take months to change supplier.
Prices react immediately, quantities do nota third good point: if its exports contain imported parts, those parts now cost more, cancelling out the price advantage
WORKED EXAMPLE 2
A large inflow of foreign direct investment arrives in a small open economy. Explain the effect on its exchange rate and its current account. [4]
Step 1: the financial account
FDI inflows are a credit in the financial account.
Step 2: the currency market
Foreign investors must buy the local currency, so demand shifts right and the currency appreciates.
Step 3: back to the current account
A stronger currency makes exports dearer and imports cheaper, so net exports fall.
Financial account surplus, current account moves towards deficitthis is the mirror rule from the last page showing up in real behaviour, not just in the accounting
💡 Exam tip
Write the chain out in order: rate → prices → volumes → revenue → balance. Skipping a link costs analysis marks.
Always add the elasticity condition. “The current account will improve provided demand is sufficiently elastic” is a mark-earning sentence.
Mention time lags. Examiners want to see that you know the effect is not instant.
Do not forget the financial account. Investment flows move exchange rates more than trade flows do on any given day.
If the country imports its raw materials, say so. A depreciation raises its own production costs and blunts the export gain.
⚠ Common mix-up
Cheaper exports do not automatically mean higher export revenue. Revenue is price times quantity, and price has fallen.
Depreciation raises import spending even as import volumes fall, because each unit now costs more.
An appreciation is not simply bad. It cuts inflation and makes imported inputs cheaper for domestic producers.
The exchange rate is not only about trade. Investment flows are a much bigger driver day to day.
Do not say the current account “must” improve. Say it should improve if demand is elastic enough, and explain why.
Up next: Living With a Current Account Deficit — what a persistent deficit does to an economy, and what a government can actually do about it.
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