IB Economics SLTopic 4 — The Global EconomyPaper 1 & 2Core idea~9 min read
What Moves a Currency
Exchange rates move every second, but almost every cause comes down to the same question: is money trying to get into this country or out of it? Answer that and you know which curve shifts. The harder half of the topic is what the movement then does to output, jobs and prices.
📘 What you need to know
Relative interest rates: higher rates attract short-term flows of money, raising demand for the currency, so it appreciates.
Relative inflation: if our prices rise faster than our competitors’, our exports lose competitiveness, demand for our currency falls and it depreciates.
Investment flows: foreign direct and portfolio investment coming in raises demand for the currency; investment going out supplies it.
The current account: rising net exports raise demand for the currency; rising imports supply it.
Tastes, growth and remittances all work the same way, by changing how many people need the currency.
Speculation drives most trading. Expectations of a rise become a rise, at least for a while.
A depreciation makes exports cheaper abroad and imports dearer at home, so net exports and AD tend to rise.
How much they rise depends on how responsive demand is to price. If demand is inelastic, the effect is small.
The clearest mechanism: interest rates
This is the chain examiners most often ask for, and it is worth learning as a sentence you can write from memory.
Notice the chain ends outside the currency market. An exchange rate movement is never the end of the story, it is the start of the effect on trade.
Every cause, and which curve it moves
Cause
What happens
Effect on the currency
Higher relative interest rates
Money flows in seeking the return
Demand rises, so it appreciates
Higher relative inflation
Exports lose price competitiveness
Demand falls, so it depreciates
Inward direct investment
Foreign firms buy assets here
Demand rises, so it appreciates
Outward investment
Our firms buy assets abroad
Supply rises, so it depreciates
Rising net exports
Foreign buyers need our currency
Demand rises, so it appreciates
Rising imports
We sell our currency to pay for them
Supply rises, so it depreciates
Remittances sent home
Workers abroad buy the home currency
Demand rises, so it appreciates
Speculation on a rise
Traders buy now to sell later
Demand rises, so it appreciates
Faster relative growth
Investors expect better returns here
Demand rises, so it appreciates
Central bank intervention
It buys or sells its own currency
Either way, deliberately
Two of these pull in opposite directions at the same time, and that is a ready-made evaluation point. Fast growth attracts investment, which lifts the currency, but fast growth also sucks in imports, which pushes it down. Which effect wins is an empirical question, not a definition.
What a depreciation does to the economy
Start with the two price effects. Exports are cheaper for foreigners, so they buy more of them. Imports are dearer at home, so we buy fewer of them. Net exports rise, and since net exports are a component of aggregate demand, AD shifts right.
A depreciation therefore hits inflation twice: once through higher demand, and once through the higher cost of imported inputs. Saying both earns more than saying either.
WORKED EXAMPLE
A UK manufacturer imports components priced at $600,000 a year. Calculate the change in its costs when the pound depreciates from £1 = $1.25 to £1 = $1.10. [4]
Step 1: cost at the old rate, dollars into pounds, so divide600,000 ÷ 1.25 = £480,000Step 2: cost at the new rate600,000 ÷ 1.10 = £545,454.55Step 3: the increase545,454.55 − 480,000 = £65,454.55Costs rise by £65,454.55This is cost-push inflation arriving through the exchange rate. The firm either absorbs it or passes it on in its prices.
The effect on each macro objective
Indicator
Effect of a depreciation
What it depends on
Current account
Should improve as exports rise and imports fall
How responsive demand is to the price change
Economic growth
Rises, because net exports add to AD
Whether there is spare capacity to produce more
Inflation
Rises, from both demand and imported costs
How much the country relies on imported inputs
Unemployment
Falls as exporters take on workers
Whether those workers have the right skills
Living standards
Mixed: more jobs, but dearer imports
Which households gain the jobs and which buy the imports
An appreciation does the opposite in each row: exports become dearer, net exports fall, AD falls, inflationary pressure eases and imported goods become cheaper. That is why a strong currency is not automatically good news, and a weak one is not automatically bad.
The elasticity condition. A depreciation only improves the current account if buyers actually respond to the lower price. If demand for exports and imports is inelastic, the country ends up selling at lower prices and paying more for the same imports, and the balance can get worse before it gets better.
WORKED EXAMPLE
Plan: “Evaluate the effects of a significant depreciation of a country’s currency.” [15]
1 Set-up
Define depreciation. State the two price effects: exports cheaper abroad, imports dearer at home.
2 Analysis with a diagram
AD and AS: net exports rise, AD shifts right, output and employment rise, price level rises.
3 The benefits
Better current account balance, growth, lower unemployment in exporting industries.
4 The costs
Imported inflation through raw materials and energy; households pay more for imported goods; if demand is inelastic the trade balance may not improve at all.
5 Judgement with a reason
“A depreciation helps an economy with spare capacity, elastic export demand and few imported inputs. For an economy that imports most of its energy and food, the inflation arrives immediately while the export gains take much longer, so the short-run effect on living standards can be negative.”
Sort the verdict by time and by structureNotice the conclusion names the type of economy. That is what makes a judgement context-aware rather than generic.
💡 Exam tip
Always start from demand or supply. Name the curve, the direction, and why, before saying the currency moved.
Use the word “relative”. Interest rates and inflation matter compared with other countries, not on their own.
Draw AD and AS for any question about the effect on the economy. It turns a list into analysis.
Say inflation twice: demand-pull from higher AD and cost-push from imported inputs.
Bring in elasticity when judging the current account. It is the condition the whole argument rests on.
Remember the time lag. Prices change immediately; buying habits and supply contracts take months.
⚠️ Common mix-up
Thinking a depreciation always improves the current account. It depends on how buyers respond.
Saying higher interest rates weaken the currency. They attract money in, which strengthens it.
Confusing the exchange rate with the price level. A currency can fall while inflation is low.
Forgetting importers. Every exporter helped by a weak currency sits next to a firm paying more for parts.
Treating speculation as irrational noise. Most currency trading is speculative, so it is part of the explanation.
Assuming appreciation is a sign of a healthy economy. It can simply mean high interest rates.
Up next: Fixed and Managed Exchange Rates — what happens when a central bank decides the market has the answer wrong, and steps in.
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