IB Economics HLTopic 4 — The Global EconomyPaper 1, 2 & 3Diagram skill~12 min read
Types of Exchange Rate System
A currency is just a product. It has a price, and that price is set in a market by demand and supply. Once you accept that, exchange rate diagrams stop being scary — they are the same demand and supply diagram you drew in your first year, with different labels on the axes.
📚 What you need to know
An exchange rate is the price of one currency in terms of another.
In a floating system, demand and supply on the foreign exchange market set the rate.
Rising demand means the currency appreciates; rising supply means it depreciates.
In a fixed system the central bank pegs the rate and buys or sells its own currency to hold it there.
A deliberate change to a peg is a revaluation (up) or a devaluation (down).
In a managed system the rate floats inside a band, and the central bank steps in only at the edges.
The price of money
On the foreign exchange market, or forex, currencies are bought and sold like anything else. If more people want dollars, dollars get dearer. If more dollars are dumped on the market, dollars get cheaper.
What an exchange rate is
£1 = $1.25 means one pound buys one dollar twenty-five
To go the other way: $1 = £1 ÷ 1.25 = £0.80
Get the direction right before you calculate anything. Going from pounds to dollars you multiply by the rate; going from dollars back to pounds you divide by it. Half of all lost calculation marks come from getting this backwards.
1. A floating exchange rate system
Nobody sets the rate. It is whatever the market clears at, minute by minute.
Demand for a currency comes from foreigners who need it — to buy that country’s exports, to invest there, to put money in its banks.
Supply of a currency comes from its own residents spending abroad — buying imports, investing overseas, holidaying elsewhere.
Excess demand pushes the price up, so the currency appreciates. Excess supply pushes it down, so the currency depreciates.
Draw this once and you can answer any floating rate question. All that changes is which curve moves and in which direction.
🧩 How to answer any floating rate question
Decide whose currency you are drawing. Put it on the axes before anything else.
Ask: does this create demand for it, or supply of it? Foreigners buying our exports create demand. Us buying imports creates supply.
Shift that one curve. Never shift both unless the question clearly involves two separate events.
Read off the new price. Higher means appreciation, lower means depreciation.
Say what it does to trade. Appreciation makes exports dearer and imports cheaper. Depreciation does the opposite.
WORKED EXAMPLE 1
A UK firm has agreed to buy a machine priced at $180,000. When the deal was signed the rate was £1 = $1.25. By payment day the pound has depreciated to £1 = $1.10. Calculate the extra cost to the firm. [3]
Step 1: cost at the original rate180,000 ÷ 1.25 = £144,000dollars to pounds, so divide by the rateStep 2: cost at the new rate180,000 ÷ 1.10 = £163,636.36Step 3: find the difference163,636.36 − 144,000 = £19,636.36The machine costs £19,636.36 more, a rise of 13.6%the dollar price never changed — a weaker pound simply buys fewer dollars
2. A fixed exchange rate system
The central bank picks a rate and defends it. If market forces would push the currency away from that peg, the bank trades in the forex market to push it back.
Currency drifting down? The bank buys its own currency using foreign reserves, raising demand.
Currency drifting up? The bank sells its own currency, raising supply.
Point 3 is back at the peg, so the rate looks unchanged. The cost is invisible on the diagram: the central bank has run down its stock of foreign currency to get there.
Parity, revaluation and devaluation
A peg at parity means one for one, such as one unit of currency A equalling one unit of currency B.
Most pegs are not at parity — they are set at whatever number suits the economy.
A revaluation is the central bank deliberately moving the peg up, making the currency stronger.
A devaluation is the central bank deliberately moving the peg down, making the currency weaker.
Word discipline. Fixed rates are revalued and devalued by a decision. Floating rates appreciate and depreciate because of the market. Using the wrong pair is one of the easiest marks to lose in this topic.
3. A managed exchange rate system
A compromise. The rate floats freely, but only inside an agreed band around a target value. Touch the top or bottom of the band and the central bank steps in.
Almost every currency in the world is managed to some degree. Pure floating and rigid pegs are the two ends of a spectrum, and most countries sit somewhere in between.
Why keep the band secret? Because if traders knew the exact level where the central bank must step in, they could buy just before it and sell the moment the bank pushes the rate back. Secrecy removes the free bet.
The three systems side by side
System
Who sets the rate
Central bank role
Main strength
Main weakness
Floating
Demand and supply
None needed
Adjusts automatically to shocks
Volatile and hard to plan around
Fixed
The central bank
Constant buying and selling
Certainty for traders and investors
Eats reserves and ties up monetary policy
Managed
The market, inside limits
Only at the edges of the band
Some stability, some flexibility
Bands can still be attacked by speculators
WORKED EXAMPLE 2
A UK exporter sells a product for £50. The rate moves from £1 = €1.15 to £1 = €1.25. Calculate the change in the euro price and comment on the likely effect on sales. [4]
Step 1: euro price before50 × 1.15 = €57.50Step 2: euro price after50 × 1.25 = €62.50Step 3: percentage change(62.50 − 57.50) ÷ 57.50 × 100 = 8.7%The pound has appreciated; the product is 8.7% dearer in eurosthe UK firm still receives £50, so its revenue per unit is unchanged — the damage is to how many units it sells
💡 Exam tip
Label the vertical axis properly: “price of currency X in terms of currency Y”. An unlabelled axis loses easy diagram marks.
Shift one curve at a time and say who is doing the buying or selling that causes it.
Use appreciate/depreciate for floating and revalue/devalue for fixed. Examiners notice.
In a fixed rate answer, always mention foreign reserves. The peg is only as strong as the pile of reserves behind it.
When a question shows two currencies, draw two diagrams: demand rising for one is supply rising for the other.
⚠ Common mix-up
A strong currency is not a good currency. It helps importers and tourists going abroad, and hurts exporters.
Multiply or divide? Converting from the currency on the left of the rate, multiply. Converting into it, divide.
Buying your own currency raises demand for it and pushes its price up. Students often say the opposite.
Managed is not the same as fixed. There is no single target rate the bank must hit, only a range it will not let the rate leave.
Appreciation does not mean the economy is doing well. It just means more people wanted the currency than were selling it.
Up next: Causes and Consequences of Currency Movements — what actually makes those curves shift, and what happens to the wider economy when they do.
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