IB Economics SLTopic 4 — The Global EconomyPaper 1 & 2Diagram skill~9 min read
Floating Exchange Rates
An exchange rate is just a price, and a currency is just a product. Once you accept that, the whole topic becomes a demand and supply diagram you already know how to draw. The only new part is working out who wants pounds and who is trying to get rid of them.
📘 What you need to know
An exchange rate is the price of one currency in terms of another, for example £1 = $1.25.
Currencies are bought and sold on the foreign exchange market, usually shortened to forex.
Under a floating system, the rate is set entirely by demand and supply, with no central bank target.
Excess demand for a currency pushes its price up: it appreciates.
Excess supply pushes its price down: it depreciates.
Demand for a currency comes from foreigners buying our exports and our assets. Supply comes from us buying imports and foreign assets.
Every currency trade is two-sided: buying pounds with dollars is also supplying dollars, so one currency appreciating means another depreciating.
Use appreciate and depreciate for floating rates. Revaluation and devaluation belong to fixed systems.
The forex diagram
Draw the market for pounds. The vertical axis is the price of a pound in dollars, the horizontal axis is the quantity of pounds traded. Now suppose American tourists start visiting Britain in greater numbers. They need pounds, so demand for pounds shifts right, and the pound gets dearer.
Every forex diagram has a twin. If you are asked to show both, draw the mirror image: demand shifting right for one currency is supply shifting right for the other.
Label your axis properly and half the confusion disappears. “Price of £1 in dollars” tells you instantly that a higher point on the axis means a stronger pound. An unlabelled axis is where students end up arguing that an appreciation is a fall.
Who wants the currency, and who is selling it
The curves are not abstract. Every point on the demand curve is somebody who needs pounds to complete a transaction, and every point on the supply curve is somebody handing pounds over to get something else.
Notice that both lists contain trade and investment. That is why exchange rates connect the balance of payments to the rest of the economy, which is where this topic goes next.
Exchange rate calculations
Paper 2 loves these because they are quick to mark and easy to get slightly wrong. The rule that saves you is to write the rate as an equation first, then decide whether you are multiplying or dividing.
The direction rule
going from £ to $ → multiply by the rate • going from $ to £ → divide by the rate
WORKED EXAMPLE
A UK firm sells goods priced at £50,000. Calculate what an American buyer pays when £1 = $1.25, and again after the pound depreciates to £1 = $1.10. [3]
Step 1: at the original rate
Going from pounds to dollars, so multiply.
50,000 × 1.25 = $62,500Step 2: at the new rate50,000 × 1.10 = $55,000Step 3: say what it means
The same British goods now cost the American buyer $7,500 less, so UK exports have become more competitive.
$62,500 falls to $55,000The price in pounds never changed. Only the exchange rate did, which is exactly the point of the question.
WORKED EXAMPLE
A trader holds $240,000 and converts it to pounds at £1 = $1.20. The pound then depreciates by 10% and she converts back. Calculate her loss. [4]
Step 1: dollars into pounds, so divide240,000 ÷ 1.20 = £200,000Step 2: the new exchange rate1.20 × 0.9 = $1.08 per poundStep 3: pounds back into dollars, so multiply200,000 × 1.08 = $216,000Step 4: the loss240,000 − 216,000 = $24,000A loss of $24,000A 10% fall in the currency produced a 10% loss on the whole holding. This is what firms mean by exchange rate risk, and why they pay to hedge against it.
Flipping the rate. If £1 = $1.25 then $1 = £0.80, because 1 ÷ 1.25 = 0.80. Questions often quote the rate one way round and ask for an answer the other way, and the flip is worth a mark on its own.
Floating: the advantages and the price of them
In favour of floating
Against floating
The rate adjusts by itself to trade imbalances
The rate can swing sharply and unpredictably
No foreign reserves are needed to defend it
Volatility makes firms nervous about contracts
Monetary policy stays free for domestic goals
Speculation can move the rate away from fundamentals
No target to be attacked by speculators
A falling currency raises imported costs
💡 Exam tip
Label the vertical axis with both currencies: “price of £1 in $”. It stops every direction error.
Decide which curve moves first, then which way. Money coming into the country is demand; money leaving is supply.
Write the rate as an equation before calculating, so multiply or divide becomes obvious.
Use appreciate and depreciate for a floating currency. Saving devaluation for fixed systems is a free accuracy mark.
Mention the other currency. One appreciating always means another depreciating.
Round money to two decimal places and keep the currency symbol on the answer.
⚠️ Common mix-up
Shifting supply when you mean demand. Foreigners buying our exports demand our currency; they do not supply it.
Thinking a stronger currency is always good news. It is good for importers and bad for exporters.
Multiplying when you should divide. Check the units of your answer: it should be in the currency you asked for.
Confusing a fall in the exchange rate with a fall in the price level. They are different prices entirely.
Using devaluation for a floating currency. Devaluation is a deliberate policy decision under a peg.
Drawing only one market when the question asks about two currencies.
Up next: What Moves a Currency — the forces that shift those two curves in real life, and what happens to output, jobs and prices when they do.
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