IB Econ Study Guide Internationals - Sunny Hills High School

Exchange rates
The exchange rate of a currency is defined as the price (the value) of a cunency expressed
in terms of another currency. For example, in December 2007, the euro3 exchange rate was
$1.45. one needed 1.45 US dollars to purchase one euro.
Foreign exchange
A foreign exchange market is a market in which
currencies are exchanged for other currencies. An
example is the market where euros and dollars are traded.
This is a 24-hour, 365 days a year world market that is
a good example of a perfectly competitive market: the
'good' is homogeneous as it makes no difference whether
a dollar is bought in Frankfurt or singapore or London;
there are very many buyers and sellers of currencies (all
major world banks participate, non-financial corporations
as well financial corporations such as pension funds,
insurance companies, hedge funds, etc.) with no player
being large enough to influence the market price of a
Floating, fixed and
A currency is traded in a floating (or flexible) exchange
rate system if market forces alone without any
government or central bank intervention determine its
value. The dollar, the euro and the British pound all float
against each other.
A fixed exchange rate system refers to the case where
the exchange rate is set and maintained at some level by
the government (or the central bank) of a country China
maintained its currency, the yuan (officially the renminbi
Appreciation and
currency; no entry barriers into the market exist as any
new bank or corporate financial
or non-financial major can enter and participale, and
this market comes closest to perfect information as any
new piece of information is available to all participants
in real time.
A distinctive characteristic of this market is that all buyers
are at the same time sellers also and vice versa. Also, if
the price of currency A expressed in terms of currency
B is e then the price of currency B expressed in terms of
currency A is (1/e).
or RMB), fixed against the dollar between 1994 and 21
July 2005 at RMB 8.28 per dollar.
. A managed exchange rate system is one where there
is no pre-announced level but either the exchange rate is
allowed to float within some uooer and lower bound or a
system in which authorities intervene when they consider
the direction or the speed of adjuslment of the currency
as undesirable. Since July 2005 the renminbi has been in a
managed float with reference to a basket of currencies.
The terms refer to changes in the price (the value) of a Figure 4.7 Appreciation of the euro against the US dollar
currency in a //oatlng (flexible) exchange rate system.
More specifically, a currency appreciates il iIs price
$1.50
increases within a floating (flexible) exchange rate system.
For example, between 2006 and 2007 the euro
$1.40
appreciated from $1 .32 to $1.45. lts price increased, as
you could buy a euro for only $1.32 in December 2006
$1.30
whereas you needed $1.45 in December 2007.
A currency depreciates if its price decreases within a
$1.20
floating (flexible) exchange rate system.
Using the same example, between 2006 and 2007
the dollar depreciated from €0.76 to €0.69. lt became
IAN
2006
IAN
2007
DEC
2007
cheaper as one needed €0.76 to buy a dollar in December ln Fig. 4.7 ihe appreciation of the euro between January
2006 while you could buy it only for €0.69 in December 2006 and December 2007 is shown. Note than in a floating
2007 .
(flexible) exchange rate system the changes are continuous
It should be clear that if currency A depreciates in terms and even though the path (1he trend) is upward, reflecting
of currency B it follows that currency B appreciates in
terms of currency A.
the appreciation, there is a lot of volatility.