Exchange rates: notes and practice questions
- This topic examines how the value of one currency is determined relative to another and the economic implications.
- Floating exchange rates are determined by the market forces of demand and supply for a currency.
- Factors influencing currency demand and supply include foreign demand for exports, domestic demand for imports, investment flows, remittances, speculation, and relative inflation/interest rates.
- Depreciation and appreciation refer to changes in floating exchange rates, while devaluation and revaluation refer to changes in fixed exchange rates.
- Changes in exchange rates impact economic indicators such as inflation, economic growth, unemployment, the current account balance, and living standards.
- Governments may intervene to maintain fixed or managed exchange rates, leading to overvalued or undervalued currencies.
How it is examined
Very frequently examined. May 2025 HL Paper 1 TZ1 Q3 was entirely 4.5: part (a) asked for the difference between floating and fixed systems for 10 marks, with a maximum of 6 if only one system is explained; part (b) asked for a discussion of the consequences of a depreciation for 15 marks. Paper 2 TZ1 Q1(d) used an exchange rate diagram for 4 marks.
- Floating exchange rates: their determination, and depreciation and appreciation of a currency. (AO2, AO4)
- Changes in the demand for and supply of a currency, from factors including foreign demand for exports, domestic demand for imports, inward and outward foreign direct investment, inward and outward portfolio investment, remittances, speculation, relative inflation rates, relative interest rates, relative growth rates, and central bank intervention. (AO2, AO4)
- The consequences of changes in the exchange rate for economic indicators such as the inflation rate, economic growth, unemployment, the current account balance and living standards. (AO3, AO4)
- Fixed exchange rates: devaluation and revaluation of a currency, and how fixed exchange rates are maintained. (AO2, AO4)
Fixed versus floating exchange rate systems. (AO3)
Guiding questions
- What sets the price of a currency, and what happens to the economy when it moves?
Linking questions
- Interest rate changes from 3.5 shift the demand for the currency.
- Relative inflation rates come from 3.3.
- The current account consequence is 4.6, and the Marshall-Lerner condition there (HL) is the quantitative version of the same story.
- Monetary union in 4.4 removes the exchange rate as a variable.
Practice questions
4 questions · 4 hardQuestion 1
HardPaper 1 · no calculator25 marks(a) Explain how a decrease in government spending on infrastructure and a depreciation of the country’s currency might affect macroeconomic equilibrium in the short run.
(b) Using real-world examples, evaluate the view that supply-side policies are the most effective way for a government to achieve economic growth.
Start by defining the key terms: government spending, currency depreciation, and macroeconomic equilibrium. Then, consider how each of these events affects a component of aggregate demand (AD). Use the AD/AS model to show the shifts and the resulting changes in the price level and real GDP for each event separately.
First, explain what supply-side policies are (both interventionist and market-based) and how they are intended to cause economic growth, using an LRAS diagram. Then, evaluate this view by considering the strengths of these policies (e.g., non-inflationary growth) and their weaknesses (e.g., time lags, costs, potential impact on equity). Compare their effectiveness to demand-side policies, considering different economic scenarios. Support your arguments with specific real-world examples of countries that have used supply-side policies.
Question 2
HardPaper 2 · calculator40 marksRead the extracts and answer the questions that follow.
Text A, Overview of the economy and government policies in Vietnam
1 Vietnam has one of the fastest-growing economies in Asia, driven by strong exports and high levels of foreign direct investment (FDI). This growth has transformed the country, lifting millions out of poverty. Major multinational corporations have established large-scale manufacturing facilities, particularly in electronics and textiles, turning Vietnam into a key hub in global supply chains.
2 This rapid industrialization, however, has created challenges. Inflation has become a persistent concern, fueled by rising domestic demand and higher global energy prices. The economy's heavy reliance on imported raw materials and components makes it vulnerable to supply chain disruptions and currency fluctuations.
3 To support its transition to a higher-value economy, the government has offered various incentives. For instance, it provides a subsidy to domestic producers of electric vehicles (EVs) to encourage green technology and reduce reliance on imported fossil fuels. The government has also been actively managing its currency, the Vietnamese dong (VND), to maintain export competitiveness.
Text B, Labour market and social development in Vietnam
1 Vietnam's economic boom has led to a significant structural shift, with millions of workers moving from agriculture to the industrial and service sectors. To ensure a basic standard of living, the government regularly increases the minimum wage. In 2022, the minimum wage was raised by an average of 6%.
2 While poverty has fallen dramatically, inequality is a growing concern. There is a widening gap in income and opportunities between major urban centres like Ho Chi Minh City and Hanoi, and the more remote, rural provinces. Although youth literacy rates are high, there is a recognized skills gap, where the education system is not fully equipping graduates for the demands of the modern high-tech manufacturing sector.
Text C, Vietnam's trade integration and environmental challenges
1 Vietnam is a member of numerous free trade agreements, including the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) and the Regional Comprehensive Economic Partnership (RCEP). These agreements have boosted exports but also increased competition for domestic firms.
2 The environmental cost of industrialization is becoming increasingly apparent. Air and water pollution in industrial zones are significant problems, creating negative externalities that affect public health and long-term sustainability. The government acknowledges these issues and has set ambitious targets for renewable energy, aiming to attract FDI into solar and wind power projects.
Table 1: Selected macroeconomic data for Vietnam
| 2016 | 2022 | |
|---|---|---|
| Real GDP (USD billion) | 205 | 409 |
| Inflation rate (%) | 2.7 | 3.2 |
| Unemployment rate (%) | 2.3 | 2.3 |
| GNI per capita (USD) | 2190 | 4010 |
Table 2: Vietnam's current account, 2023 (billions of USD)
| 2023 | |
|---|---|
| Exports of goods | 355 |
| Imports of goods | 330 |
| Balance of trade in services | –10 |
| Primary income | –20 |
| Secondary income | 15 |
| Current account balance |
Table 3: Development and trade data for Vietnam
| 2016 | 2022 | |
|---|---|---|
| Population (million) | 93 | 99 |
| Gini coefficient | 0.344 | 0.357 |
| FDI inflows (USD billion) | 12.6 | 15.7 |
(a) (i) Define the term subsidy indicated in bold in the text (Text A, paragraph 3).
(a) (ii) Define the term Gini coefficient indicated in bold in Table 3.
(b) (i) Using information from Table 2, calculate Vietnam's balance of trade in goods for 2023 in billions of USD.
(b) (ii) Using information from Table 2 and your answer to part (b)(i), calculate Vietnam's current account balance for 2023 in billions of USD.
(b) (iii) Sketch a demand and supply diagram to show the effect of a subsidy on the market for electric vehicles in Vietnam (Text A, paragraph 3).
(c) Using an AD/AS diagram, explain how an increase in foreign direct investment (FDI) could affect economic growth in Vietnam (Text A, paragraph 1).
(d) Using a Lorenz curve diagram, explain the change in income inequality in Vietnam between 2016 and 2022 as shown in Table 3.
(e) Using an externalities diagram, explain how industrial production can lead to market failure in Vietnam (Text C, paragraph 2).
(f) Using an exchange rate diagram, explain how a rise in export revenue could affect the value of the Vietnamese dong (VND).
(g) Using information from the text/data and your knowledge of economics, discuss the challenges Vietnam faces in achieving sustainable economic development.
Think about what a government gives to a firm to help it produce more or sell at a lower price. What is the nature of this financial support?
This is a numerical measure of income inequality. How is it derived and what do its extreme values (0 and 1) represent?
The balance of trade in goods is the value of goods exported minus the value of goods imported.
The current account balance is the sum of the balance of trade in goods, the balance of trade in services, primary income, and secondary income.
A subsidy lowers the cost of production for firms. How does this affect the supply curve? Show the new equilibrium price and quantity.
FDI is a form of investment. Which component of aggregate demand (AD) does investment fall under? How would an increase in this component affect the AD curve and, consequently, real GDP?
First, look at the Gini coefficient data in Table 3. Did it increase or decrease? What does this mean for income inequality? Then, draw a Lorenz curve diagram showing two curves, one for 2016 and one for 2022, that reflects this change.
Industrial production often creates pollution. Is pollution a cost to the producer or to society? This creates a divergence between private costs and social costs. Illustrate this on a diagram and explain why it leads to overproduction.
When Vietnam's export revenue rises, what must foreigners do to pay for these exports? Does this affect the demand for or supply of the Vietnamese dong? Show the effect on an exchange rate diagram.
Sustainable development has economic, social, and environmental dimensions. Use the stimulus material to identify challenges in each of these areas (e.g., inflation, inequality, pollution). Then, consider any mitigating factors or policies mentioned. Conclude with a balanced judgement on the severity of these challenges.
Question 3
HardPaper 1 · no calculator25 marks(a) Explain two factors that could cause an appreciation of a country’s currency in a floating exchange rate system.
(b) Using real-world examples, evaluate the likely effects of a currency appreciation on a country’s rate of inflation and its economic growth.
Start by defining 'appreciation' and 'floating exchange rate'. Then, think about the demand for and supply of a currency. What would cause the demand to increase or the supply to decrease? For each factor, use a diagram to illustrate the effect on the exchange rate.
Consider both the demand-side and supply-side effects of a stronger currency. For inflation, think about the prices of imports (both consumer goods and raw materials). For economic growth, think about the net exports component of aggregate demand. Your evaluation should consider factors that determine the size of these effects, such as the price elasticity of demand for exports and imports, and discuss potential conflicts or trade-offs. Use a specific country example to support your arguments.
Question 4
HardPaper 1 · no calculator25 marks(a) Explain the factors that can cause an appreciation of a currency in a floating exchange rate system.
(b) Using real-world examples, discuss the view that a government should always intervene to prevent a rapid appreciation of its currency.
Start by defining what a floating exchange rate system is and what 'appreciation' means. Then, think about the two sides of the foreign exchange market: demand for the currency and supply of the currency. What would cause demand to rise or supply to fall? Use a diagram to illustrate your points.
This question asks you to evaluate a policy stance. First, explain the negative consequences of a rapid appreciation that might prompt a government to intervene. Then, consider the potential benefits of appreciation, or the drawbacks and costs of intervention. The word 'always' is crucial – are there situations where intervention might not be the best policy? Use examples like Switzerland or Japan to support your arguments.
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Where marks are lost
- No real-world example, or a stated one. An answer that names a country and stops cannot reach the top two bands.
- One-sided argument. Balance is an explicit axis. A student who argues only that a policy works is capped at 9 out of 15 on that axis alone.
- Diagram present but not explained. The diagram bullet escalates across three bands: included, included and explained, included and fully explained. A diagram dropped into an answer without prose that refers to it sits at 5 to 6 on a 10-mark part.
