IB Docs (2) Team
Floating exchange rates
.jpg "image: https://gcon4.com/")
Introduction
This lesson introduces exchange rates, which can be described as the price of one currency relative to another. Your students also need an understanding that the exchange rate of a country impacts on businesses as well as consumers. Your classes may also be under the misconception that a strong currency will always have a positive impact on the economy. Perhaps this is a symptom of my current country, Turkey, which is constantly battling against a falling currency. In reality a government or central bank must try to balance the interests of all stakeholders in the economy - consumers, exporters, importers and domestic businesses.
Enquiry question
Explain how the exchange rate of a country is determined by changes to supply or demand for the currency.
Lesson time: 80 minutes
Lesson objectives:
Explain that the value of an exchange rate in a floating system is determined by the demand for, and supply of, a currency.
Draw a diagram to show determination of exchange rates in a floating exchange rate system.
Calculate the value of one currency in terms of another currency. (HL only)
Calculate the exchange rate for linear demand and supply functions. (HL only)
Plot demand and supply curves for a currency from linear functions and identify the equilibrium exchange rate.
Using exchange rates, calculate the price of a good in different currencies.
Teacher notes:
1. Beginning activity - begin with the prezi and the opening question and then discuss this as a class. (Allow 5 minutes in total)
2. Processes - technical vocabulary - the students can learn the background information from the videos, activities 1 - 3 and the list of key terms. (25 minutes)
3. Applying the theory - activity 4 and 5 contain a short response exercises. (15 minutes)
4. P3 question - activity 6 is HL only and includes a P3 question. (25 minutes)
5. Reflection - activity 7 contains a short commentary which discusses how (and why) some nations might be deliberately allowing their currencies to fall in value to gain a competitive advantage. (10 minutes)
Beginning activity
Which currencies do you think are the world's most valuable? Which are the least valuable? You might be surprised by the answer, which you can find on the following presentation. 
Most valuable currencies
Who benefits most from a strong or weak currency?
Hint:
A strong currency means that you as a consumer can purchase imported goods and services cheaper in terms of your own currency. Similarly businesses which rely on importing products from overseas, such as retail businesses, will benefit from a stronger currency.
However, a strong currency is unpopular with manufacturers who fear that a strong national currency makes their own products less competitive, relative to goods and services produced overseas. This is a view that the new President of the US has emphasised on a number of occasions, with strong condemnation of nations such as Japan, China and Germany accused of deliberately making their currencies weaker to under cut American products.
Key term:
Exchange rate - the value of one currency expressed in terms of another.
Floating exchange rate system - an exchange rate system where by the currency rate is determined by supply and demand, without outside influence from the government.
Appreciation - when a currency rises in value as a result of changes to demand and / or supply of the currency.
Depreciation - when the value of the currency falls as a result of changes to demand and / or supply of the currency.
The activities on this page are available as PDF file at: 
Floating exchange rates
Activity 1: Investigating floating exchange rates
Investigate the term floating exchange rates before answering the questions:
(a) What are exchange rates?
The price of one currency expressed in terms of another.
(b) What are the three types of exchange rate system?
Fixed, floating and managed exchange rate systems.
(c) What is a floating exchange rate system?
An exchange rate system where by the currency rate is determined by supply and demand, without outside influence from the government.
(d) Are there any examples of pure floating exchange rates in the world?
In reality there are no genuinely free floating exchange rate systems in the world. Governments will always manage their exchange rate so that it lies within the value that they desire.
Determining supply and demand for a currency
The following short video provides an explanation of the market for US$ and Euros. Both the EU and USA operate floating exchange rate systems. Use the information contained in this video to complete activities 2-4.
Activity 2: The supply of a currency
The diagram to the right illustrates the market for US$, relative to the Euro.
(a) Where does the world supply of $s come from?
From the US itself, US institutions and anyone else currently holding the currency but wishing to exchange it for a different one.
(b) Explain the likely factors which determine the level of supply of US$s
- the level of domestic demand for imported goods and services. For example, when the US imports products from the EU it must pay for those goods in ͼ, and to purchase ϵ it must sell (supply) US $s.
- the level of overseas investment
- remittances sent overseas as well as currency transfers by speculators.
(c) Explain the impact on the market for US$ of a rise in demand for imported EU products.
A right shift in the supply of USs and (ceteris parabus) a fall in the value of the currency, relative to the Euro.
Activity 3: Demand for a currency
(a) Where does the world demand for $s come from?
From outside the US, foreign institutions and anyone else currently holding foreign currency and wishing to exchange it for $s
(b) Explain the likely factors which determine the level of demand for US$s
- demand for a country’s exports
- the level of investment by overseas citizens in a nation
- foreign currency derived from remittances from abroad
- speculators looking to make a profit on changes in currency values.
(c) Illustrate the effect on the market for the US$ of a rise in demand for US products in the Euro zone.
Following a rise in demand for US goods and services, there would be an increase in the price of the American $ as a result of an increase in demand for the US.
Activity 4: Exchange rates in practise
Complete the following table by filling in the missing blanks.
| External event | Impact on demand for US $ | Impact on the supply of US $ | Impact on the exchange rate for $ |
| A rise in the popularity of American products | rise | unchanged | the $ will rise in value |
| An increase in the popularity of British products in the USA | unchanged | rise | the $ will fall in value |
| A sharp rise in American GDP | rise due to a rise in investment flows | rise | unclear |
| A slowdown in the world economy | fall | unchanged | the $ will fall in value |
| A sharp rise in the price of rare earths (America is a major importer of rare earths) | unchanged | rise | the $ will fall in value |
| A rise in American interest rates | rise due to an increase in hot money flows | fall | rise |
| A rise in personal tax rates in the USA | unchanged | fall | the $ will rise in value |
Activity 5: Investigation
When a current account is either in surplus or deficit, will it be corrected automatically under a freely floating exchange rate system?
Hint:
When the current account is in deficit there will be a surplus of the currency in the exchange market. This should lead to the currency automatically falling in value, making exports cheaper as well as imports more expensive. - Similarly, when the current account is in surplus, demand for the currency will be higher than supply. In this situation the currency will automatically rise in value, making import levels cheaper and exports more expensive to purchase.
- That said the above depends to some extent on the PED elasticity for the goods and services traded internationally.
However:
- The automatic stabilisers may not work if the market for the currency is subject to excessive currency transactions through speculation, political uncertainty and / or net investment flows. The current account is only one factor determining the market for traded currencies.
- In reality there are no truly floating exchange rates in the world as governments will always influence the market for a currency using the central banks foreign currency reserves. The video for example highlights that the government controls the size of the money supply and therefore one of the two influences on price (exchange rate).
Activity 6: Competitive devaluations will be a race to the bottom, triggering real recession
Read the following article and then answer the question which follows:
Extracted from: the economic times, August 20, 2015.
Ruchir Sharma of Morgan Stanley has warned of a global recession, driven by collapsing growth in China. World growth is dropping well below IMF predictions, with emerging markets performing especially badly.
Currency after currency is falling against the dollar. The Brazilian real is down over 23% since the start of the year. The Russian rouble has lost more than half its value since 2013. This raises fears that more than simply market forces are at work. It suggests that competitive devaluation may have begun, with countries manipulating their currencies downward to curb imports and promote exports. Such competition must be stalled. It will be a race to the bottom that exacerbates the impact of slowing Chinese growth, and ensures a truly deep recession.
Explain why countries may be engaging in a race to the bottom?
Countries have been accused of manipulating their currencies downwards to curb imports and promote exports. The lower the currency value then the more competitive export industries become and the lower the threat from imported products. A cheaper currency will increase inflationary pressures in the economy but some governments may well believe that inflation is a price worth paying for increased sales overseas as well as lower import levels.
However, this is a zero sum game as far as the world economy is concerned. If nations collectively reduce their import levels then world wide exports will fall, reducing global economic growth.
Activity 7: Paper three question on international trade
1. A student from Istanbul wins a place at London university at the market exchange rate of 20TL = 1 UK£. The expenses of studying in London include an annual tuition fee of UK £15,000 and the student also expects to incur living expenses of £1,500 per month.
(a) Define the term exchange rate. [2 mark]
The price of one currency expressed in terms of another.
(b) Calculate the expected annual expenses measured in Turkish Lira. [2 marks]
Expenses calculated as (1,500 x 12) x 20 = 360,000 (monthly expenses) + 300,000 = 660,000 TL
Shortly before arriving in the country the TL depreciates against the UK£ by 11 %.
(c) Calculate the new exchange rate between the two countries. [2 marks]
22 TL = 1£
(d) Calculate the new yearly cost in TL required to pay for tuition and living expenses during their first year of studies, as a result of the devaluation of the currency. [2 mark]
£33,000 x 22 = 726,000 TL
(e) Use the following demand curves to illustrate the impact of the depreciation on the market for both Turkish universities and Turkish students studying overseas. [4 marks]
With UK and Turkish universities being substitute goods demand for Turkish colleges is inversely proportional to the price of UK universities. When the TL devalues against the £ the price of education (in TL) will rise reducing demand from D1 to D2, at the same time increasing demand for university places in Turkey from D1 to D2.
(f) The exchange rate between the TL and the UK£ / US $ is illustrated in the following table:
Price of TL / UK£ | Price of TL / US $ | |
2019 | 8.0 | 5.7 |
2020 | 9.8 | 7.8 |
2021 | 10.5 | 8.9 |
2022 | 22 | 18.6 |
Using the following table, express the exchange rate of TL as an index for 2019-2022. [3 marks]
Price of TL / UK£ | Price of TL / US$ | |
2019 | 100 | 100 |
2020 | 122.50 | 136.84 |
2021 | 131.25 | 156.14 |
2022 | 275 | 326.32 |
(g) Explain why some economists use an index to represent statistical data such as exchange rates. [2 mark]
Economists will sometimes use an index to display statistical information, making it is easier for the reader to compare the statistical information provided. Indexes are typically used in representing inflation and a nation’s terms of trade or exchange rate.
(h) Based on the information contained in questions (g - i), suggest whether attending US universities might be more accessible to Turkish students. [3 marks]
Unfortunately for young Turkish students wishing to study overseas US universities have become relatively more unaffordable than both UK and Turkish universities, with the TL depreciating at an even faster rate against the $ than against £.
(i) Using the information in this passage and your knowledge of economics, recommend an appropriate policy that the Turkish government might take to strengthen its own currency [10 marks]
Possible policies may include (but are not restricted to):
- through contractionary monetary policy (reducing the money supply in Turkey through higher interest rates)
- intervention in the market for foreign exchange (responses should recognise that such a policy is likely to be possible open short term)
- policies aimed at reducing imports (expenditure switching policies)
- a combination of policies.
Responses in section (j) should be graded according to the following mark bands:
Maximum mark 10
Criteria | Mark |
There is no clear policy answer to the question but some limited:
| 1-2 |
There is a policy answer to the question with limited:
| 3-4 |
There is a clear policy answer to the question with satisfactory:
| 5-6 |
There is a clear policy answer to the question with good:
| 7-8 |
There is a clear policy answer to the question with excellent:
| 9-10 |
A mark scheme for activity 7 (HL activity) can be accessed at: 
Exchange rate markscheme
Twitter
Facebook
LinkedIn