IB Economics - Determination of Freely Floating Exchange Rates

This study note for IB economics covers Determination of Freely Floating Exchange Rates

In a freely floating exchange rate system, the value of a currency is determined by the forces of demand and supply in the foreign exchange market. Unlike fixed or pegged exchange rate systems where a government or central bank intervenes to maintain a currency's value, a floating exchange rate adjusts according to market dynamics. Understanding the factors that influence demand and supply for currencies is crucial in predicting exchange rate movements.

Determination of Exchange Rates in a Freely Floating System

• Exchange Rate: The price of one currency in terms of another.
• Freely Floating Exchange Rate System: A system where the value of a currency is determined by the market forces of demand and supply without direct government or central bank intervention.

How Exchange Rates Are Determined:

1. Demand for a Currency:
   • When foreign investors or consumers need a currency, they increase its demand.
   • Factors increasing demand:
     • Foreigners wanting to buy a country's exports.
     • Foreigners investing in a country's financial markets (e.g., stocks, bonds).
     • Foreign direct investment (FDI) from abroad.
     • Speculators expecting the currency to appreciate in the future.
2. Supply of a Currency:
   • Supply increases when residents of a country want foreign currencies.
   • Factors increasing supply:
     • Domestic consumers importing goods and services.
     • Domestic investors investing abroad.
     • Speculators expecting the currency to depreciate in the future.

Real-World Example:

• The US Dollar: The USD is widely demanded globally because of America's large export market, safe financial markets, and high levels of foreign investment. This demand supports the value of the dollar on global markets.

Causes of Changes in Exchange Rates

Changes in exchange rates occur due to shifts in demand and supply for currencies. These shifts are driven by various factors:

1. Foreign Demand for Exports:
   • If a country's exports are in high demand, foreign buyers need the country's currency, increasing demand.
   • Example: A surge in demand for Japanese technology increases demand for the yen, causing it to appreciate.
2. Domestic Demand for Imports:
   • If residents of a country import more goods and services, they need foreign currencies, increasing supply of their currency.
   • Example: High demand for European luxury goods in China can increase the supply of the Chinese yuan, leading to its depreciation.
3. Relative Interest Rates:
   • Higher interest rates attract foreign capital as investors seek better returns, increasing demand for the currency.
   • Example: If the US raises interest rates, it attracts foreign investors seeking higher returns, increasing demand for the dollar.
4. Relative Inflation Rates:
   • High inflation erodes a currency's value, reducing its demand and increasing its supply as purchasing power decreases.
   • Example: If the UK experiences higher inflation than its trading partners, the pound may depreciate because foreign buyers find UK goods more expensive, reducing demand for the pound.
5. Investment from Overseas:
   • Foreign Direct Investment (FDI): Direct investment into production or business in another country. Increases demand for the local currency.
   • Portfolio Investment: Investment in financial assets like stocks or bonds. Also increases currency demand.
   • Example: Increased FDI in India from tech giants boosts demand for the Indian rupee.
6. Speculation:
   • Expectations of future currency movements influence demand and supply.
   • Example: If traders expect the euro to appreciate due to economic recovery in the Eurozone, they buy euros, increasing its value.

Appreciation vs. Depreciation of a Currency

• Appreciation: An increase in the value of a currency in terms of another currency.
  • Occurs when demand for a currency exceeds its supply.
  • Example: The Swiss franc often appreciates during global financial uncertainty as it is seen as a "safe-haven" currency.
• Depreciation: A decrease in the value of a currency in terms of another currency.
  • Occurs when supply of a currency exceeds its demand.
  • Example: The Turkish lira has depreciated significantly in recent years due to high inflation and political instability reducing investor confidence.

Key Points to Remember:

• Appreciation makes exports more expensive and imports cheaper.
• Depreciation makes exports cheaper and imports more expensive.

Glossary of Key Terms

• Appreciation: Increase in the value of a currency relative to another currency.
• Depreciation: Decrease in the value of a currency relative to another currency.
• Exchange Rate: The value of one currency in terms of another currency.
• Foreign Direct Investment (FDI): Investment in a country by establishing business operations or acquiring business assets.
• Floating Exchange Rate System: A currency system where the exchange rate is determined by market forces without direct intervention.
• Inflation Rate: The rate at which the general level of prices for goods and services is rising, eroding purchasing power.
• Interest Rate: The cost of borrowing or the return on savings; influences the flow of capital and currency values.
• Portfolio Investment: Investment in financial assets such as stocks and bonds in a foreign country.
• Speculation: Trading in currencies with the hope of making a profit from future changes in exchange rates.

Possible IB Economics Essay Questions

1. "Discuss the factors that determine exchange rates in a freely floating system, using real-world examples to illustrate your answer."
2. "Evaluate the impact of interest rate changes on the value of a currency in a floating exchange rate system."
3. "To what extent do relative inflation rates between countries affect their exchange rates? Use specific examples in your analysis."
4. "Explain the potential impact of foreign direct investment on a country’s exchange rate, using appropriate examples."
5. "How do speculative activities influence exchange rate movements? Illustrate your response with recent examples."

Recent Real-World Data and Examples

• US Dollar vs. Euro: In 2023, the USD depreciated against the euro due to expectations of lower interest rate hikes by the Federal Reserve compared to the European Central Bank.
• Japanese Yen: In 2024, the yen weakened against major currencies as Japan maintained ultra-low interest rates while other central banks tightened monetary policy.
• British Pound: The pound has experienced fluctuations due to Brexit-related uncertainties and changes in UK interest rates compared to the Eurozone.

Retrieval Questions for A-Level Students

1. What determines the value of a currency in a freely floating exchange rate system?
2. Name three factors that can lead to the appreciation of a currency.
3. Explain how relative interest rates affect currency demand and supply.
4. What is the difference between foreign direct investment and portfolio investment? How do each impact exchange rates?
5. What is the effect of high domestic inflation on a currency’s value in a floating exchange rate system?