Free-Floating ER

3.
2 Freely floating exchange rates
Definitions:
 Exchange rate – value of a currency expressed in terms of another currency.

(In other words: price of the currency in terms of another currency).
 Floating exchange rates (system) – when the exchange rate of a currency
is determined by the supply and demand for that currency.
 Appreciation (of a currency) – occurs when a currency increases in value
against another currency, i.e. it can buy more of another currency.
 Depreciation (of a currency) – occurs when a currency loses value
against another currency, i.e. it can buy less of another currency.
Determination of Freely Floating Exchange Rates
The diagram above for floating exchange rates shows that the value of the US Dollar
($) is at e1 where Supply (S) = Demand (D) for USD. At that exchange rate (e1), the
equilibrium quantity of US Dollars is Q1. It is important to note that on the Y axis the
value of $ is expressed in terms of how many Euros you can buy with $1 (There are
variations of this diagram, hence, always consult your teacher about which one is the
most appropriate). The higher the value of the US Dollar, the more Euros you will be
able to purchase with 1 USD. The lower the value of the USD – the less Euros
$1 will be able to buy.
For people doing the IB Higher Level Economics course, you need to know some
maths connected to floating exchange rates:
Say, you are given that 1 GBP = 1.25 EUR. You have to know how to express the
value of 1 EUR in terms of GBP. How? If 1 GBP = 1.25 EUR, then 1 EUR = 1/1.25
GBP –> 1 EUR = 0.80 GBP
Changes in Floating Exchange Rates
2 diagrams showing an appreciation in the floating exchange rates:
Diagram 1
Diagram 2
2 diagrams showing a depreciation in the floating exchanges rates:
Diagram 3
Diagram 4
For your IB Economics course you need to know the following factors affecting
supply/ demand of currencies and hence, their floating exchanges rates:
 Foreign demand for a country’s export:

o Foreign demand for a country’s export increases. To buy larger
quantities of that export foreigners must have more of that country’s
currency. So, the demand for the exporting country’s currency
increases and hence, its currency appreciates. (Diagram 1)
o If the demand for a country’s export decreases, the demand for that
country’s currency will fall and therefore, the currency will depreciate.
(Diagram 3)
 Domestic demand for foreign imports:
o Demand for a foreign import increases. To buy more of that import
people need to get more of that country’s currency. To acquire that
currency, they must sell their own currency. Supply of
domestic currency increases and hence, it depreciates. (Diagram 4)
o If the demand for a foreign import decreases, the domestic currency
will appreciate because less of the foreign currency will be needed and
so the supply of the domestic currency will decrease. (Diagram 2)
 Relative interest rates:
o Interest rates in country A are higher than interest rates in country B ->
people of country B want to keep their money in country’s A banks,
hence they require more of country’s A currency. Demand for country’s
A currency increases and it appreciates. (Diagram 1) Also, people
living in country A might supply less currency to earn a higher interest
in their domestic banks, hence the supply of the currency decreases
and it appreciates. (Diagram 2)
o Interest rates in country A are lower than interest rates in country B ->
people in country A want to keep their money in country’s B banks
offering higher interest so they start purchasing more of their currency
by selling more of their own. Supply of country A currency increases
and it depreciates. (Diagram 4) Also, foreigners might decide to keep
more of their money in country’s B banks and so demand less of
country’s A currency. Demand falls and country’s A currency
depreciates. (Diagram 3)
 Relative inflation rates – the inflation of the country does not directly affect
the exchange rate. However, relative inflation rate (compared to other
countries’ inflation) does.
o Say the inflation rate in the US is 5% and the inflation rate in Germany
is 2%. Because goods and services are becoming more expensive in
the US quicker than in Germany people might choose to buy
goods/services from Germany. This action requires to have euros and
to get euros you need to sell USD, hence, the supply of USD increases
and the US Dollar depreciates. (Diagram 4) Or it could be the case that
US exports are becoming less competitive when compared to
Germany’s (because their price is increasing faster) so people might
start demanding less of US exports and more of Germany’s. Therefore,
demanding less US Dollars -> demand for USD decreases and the
currency depreciates. (Diagram 3)
o If the inflation in the US is lower than in Germany the story reverses.
People will demand more US exports, so the demand for the currency
will grow (Diagram 1), leading to currency’s appreciation. Also, people
might supply less of USD as they might be needing less euros because
the imports became too expensive (Diagram 2), leading to appreciation
of the US Dollar.
 Investment from overseas in a country’s firms (foreign direct investment
and portfolio investment):
o For foreigners to invest in a country (FDI and portfolio investment) they
must acquire that country’s currency. Hence, they will increase the
demand for that currency and it will appreciate (Diagram 1). It is also
possible that they will decrease supply, because some investors might
already be holding USD which they were planning to sell but decide not
to (Diagram 2).
o Important to note that this works both ways: foreign investors might
decide to pull the money out (sell the factories or their shares) and then
exchange that country’s currency for another one. Leading to
increasing supply (and possibly falling demand) and currency’s
depreciation (Diagrams 3 and 4).
 Speculation (“hot money” flows): same as relative interest rates as
speculators usually chase higher interest rates.
Exchange rate change effects
You need to know how a change in the value of a currency will affect:
Exchange rate change effect on inflation rate

As with everything in economics – IT DEPENDS. Especially on what the country in
consideration exports and imports.
Currency appreciation
 Exports – less competitive internationally because their price seems higher to

foreigners. This might lower aggregate demand and decrease inflation
(Keynesian model) if the economy was at its potential or the bottleneck.
Otherwise, changes in exports arising from changes in exchange rate will not
affect inflation much.
 Imports – they now seem cheaper due to appreciation of the currency. That
means every firm which uses imports in their production process as inputs will
face lower costs of production. Hence, the price level in the economy should
fall (AS shifts down) and inflation decrease as a result of appreciation in the
exchange rate. However, when evaluating you could mention that producers
might keep the same prices and just increase their profits.
Currency depreciation
 Exports – become more competitive internationally. Therefore, as demand for

exports grows, AD increases and might push the economy to the bottleneck
or its potential resulting in increasing inflation rate. Goods/services which
have low PEDs (price elasticity of demand) will not be likely to affect the AD
by much (e.g. oil).
 Imports – seem more expensive and therefore, producers might face growing
production costs. A lot of industries use oil as an input in their production
process. If the country considered is a net oil importer it will be very likely to
face increases in inflation rate due to depreciating exchange rate (AS shifts
up).
Exchange rate change effect on employment and economic growth

To find the effect of changing exchange rates on employment and economic growth
we need to do a similar analysis as we did with the effect on inflation.
Currency appreciation
 Exports – less competitive, lower demand for them, producers might have to
cut production, hence, increasing unemployment and lower economic growth
(or even possibly falling GDP). If the country is exporting oil (or other low PED
goods/services) the effect will be much smaller.
 Imports – seem cheaper, so if they are used as inputs, producers face lower
production costs and that might encourage to increase the quantities
produced. Therefore, increasing employment and economic growth (GDP
grows) as AD shifts to the right. However, because imports seem cheaper,
people might substitute away from domestic goods to imported ones and that
would lead to falling employment and lower GDP.
Currency depreciation
 Exports – more competitive internationally. As quantity demanded grows,

producers hire more workers and increase production -> employment grows
and GDP increases. The size of this effect might depend on the price
elasticities of exports.
 Imports – seem more expensive. Possible higher production costs -> lower
production quantities -> workers being fired and GDP falls. However, people
might substitute from imports which now seem more expensive to
domestically produced goods. As AD shifts to the right (because C component
increases and M component decreases) producers increase quantities
produced, hire workers and GDP grows.
Exchange rate change effect on current account balance

The effect of changes in the exchange rate on the current account balance depends
on the same thing: on goods and services that the considered country
exports/imports. To be precise – on the PEDs of the country’s exports and imports.

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3.

2 Freely floating exchange rates

 Exchange rate – value of a currency expressed in terms of another currency.

Determination of Freely Floating Exchange Rates

 Foreign demand for a country’s export:

Exchange rate change effect on inflation rate

 Exports – less competitive internationally because their price seems higher to

 Exports – become more competitive internationally. Therefore, as demand for

Exchange rate change effect on employment and economic growth

 Exports – more competitive internationally. As quantity demanded grows,

Exchange rate change effect on current account balance

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