Exchange rates

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.

Activity 1

Investigate the term floating exchange rates before answering the questions:

(a) What are exchange rates?

(b) What are the three types of exchange rate system?

(c) What is a floating exchange rate system?

(d) Are there any examples of pure floating exchange rates in the world?

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InThinking www.thinkib.net/Economics 1
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?

(b) Explain the likely factors which

determine the level of supply of US$s

(c) Explain the impact on the market for

US$ of a rise in demand for imported EU
products.

Activity 3: Demand for a currency

(a) Where does the world demand for $s

come from?

(b) Explain the likely factors which

determine the level of demand for US$s

(c) Illustrate the effect on the market for the

US$ of a rise in demand for US products in
the Euro zone.

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Activity 4: Exchange rates in practise

Complete the following table by filling in the missing blanks.

Impact on demand Impact on the Impact on the

External event
for US $ supply of US $ exchange rate for $
A rise in the
the $ will rise in
popularity of rise
value
American products
An increase in the
popularity of British
products in the USA
A sharp rise in
American GDP
A slowdown in the
world economy
A sharp rise in the
price of rare earths
(America is a major
importer of rare
earths)
A rise in American
interest rates
A rise in personal
tax rates in the USA

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?

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InThinking www.thinkib.net/Economics 3
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?

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InThinking www.thinkib.net/Economics 4
Activity 7: Paper three question on international trade

1. A student from Mumbai wins a place at an American university at the market exchange
rate of 64 Rupees = 1 US$. The expenses of studying in America include an annual tuition
fee of US $35,000 and the student also expects to incur living expenses of $1,000 per month.

(a) Define the term exchange rate. [2 mark]

(b) Calculate the expected annual expenses measured in Indian Rupees. [2 marks]

Shortly before arriving in the country the Rupee depreciates against the US$ by 8.75 %.

(c) Calculate the new exchange rate between the two countries. [2 marks]

(d) Calculate the new yearly cost in Rupees 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]

(e) Use the following demand curve to illustrate the depreciation of the INR. [2 marks]

(f) Using the diagram from part (d), explain two reasons why the INR may have depreciated
relative to the US$. [2 marks]

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(g) The exchange rate between the INR and the US$ / Euro € is illustrated in the following
table:

Price of INR / US$ Price of INR / Euro

€
2016 62 73
2017 67 79
2018 66 77
2019 71 81

Using the following table, express the exchange rate of India as an index for 2016 and 2017.
[3 marks]

Price of INR / US$ Price of INR / Euro

€
2016 100 100
2017
2018
2019

(h) Explain why some economists use an index to represent statistical data such as exchange
rates. [2 marks]

(i) Given the data in (f) calculate the exchange rate between the US$ and the Euro during the
same years. [2 marks]

Price of US$ / €
2016
2017
2018
2019

(j) Based on the information contained in questions (f - i), suggest whether attending
European universities might be more accessible to Indian students. [2 marks]

(k) Explain how the depreciation of the INR is likely to affect the number of Indian students
studying abroad. [2 marks]

(l) Discuss the argument that the Indian government should pegs its national currency to
either the US$ or ϵ in order to provide greater security for its citizens? [2 marks]

© Mark Johnson,
InThinking www.thinkib.net/Economics 6