IB Economics SL: City Honors School
IB Economics SL
Unit 3: International Economics
Mr. R.S. Pyszczek, Jr.
City Honors School
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Explain that gains from trade include lower prices for consumers, greater choice for
consumers, the ability of producers to benefit from economies of scale, the ability to
acquire needed resources, a more efficient allocation of resources, increased
competition, and a source of foreign exchange.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Lower Prices: Countries like individuals can specialize in
particular areas of expertise. This means they can produce
more efficiently than if each country tried to produce enough
of everything for all its needs
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Taking Advantage of Different Factor Endowments: No two
countries share the exactly the same resource base. Trade takes
advantages of these differences between countries
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Economies of Scale: As production levels grow ever larger to
meet international demand, the specialization of managers and
the introduction of expensive technology can improve the
productivity of a given business sector.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Increased Variety/Choice: We are an interdependent wordl economy.
As the number of countries in the global market has grown, so has
the amount of choice. While some find these choices overwhelming,
others enjoy the power it gives to consumers to make decisions
about their purchases
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Acquisition of needed resources: Some countries lack critical
goods to improve their standard of living. In some cases,
production of a needed good is simply impossible. Trade is the
only way to get it.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Competition can improve efficiency: When a company controls a
market, it lacks competitive incentive to provide good service and
lower costs. When domestic markets are opened to foreign
competition, companies are pressed into lowering prices and
improving service or they suffer from foreign competition.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Political Benefits: Economists and Political thinkers generally
agree that trade and integration have consistently encouraged
compromise and resolution over conflict and antagonism.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The Benefits of Trade

Efficiency and Exports = growth and development: Development
economists have concluded that exports can be a path to significant
economic growth. When countries develop their comparative
advantages, they become competitive and export to world markets
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
The World Trade Organization (WTO)

Describe the objectives and functions of the WTO.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Aims of the World Trade Organization (WTO)

Trade without discrimination

Freer Trade through negotiation
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Aims of the World Trade Organization (WTO)

Predictability through binding and transparency

Promoting fair competition

Encourage development
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Functions of the World Trade Organization (WTO)

Provide a forum for trade negotiation

Execute WTO agreements

Evaluate and rule on trade complaints by member countries
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Functions of the World Trade Organization (WTO)
 Provide
technical assistance to developing countries on
trade issues
 Track
changes in member trade policies
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Supporters View of the World Trade Organization (WTO)

The WTO Promotes peace.

The WTO provides a place to handle disputes constructively

The WTO is based on rules rather than power
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Supporters View of the World Trade Organization (WTO)

Free Trade cuts the cost of living

Trade provides greater consumer choice and variety

Trade boost incomes
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Supporters View of the World Trade Organization (WTO)

Trade increases economic growth.

The WTO system encourages efficiency and simplicity

WTO agreements shield countries from narrow interests
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Critics’ View of the World Trade Organization (WTO)

Poor countries sometimes cannot afford trade representatives.

Rich countries and individuals are getting richer faster than
everyone else
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Critics’ View of the World Trade Organization (WTO)

Agricultural subsidies in rich countries hav not been reduced.

The protection of intellectual property rights. (lack of
protection)
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Free Trade
Critics’ View of the World Trade Organization (WTO)

Despite claims to equalize the trade environment, WTO
negotiations favor rich countries

It is argued that most of the gains in trade have come from
trade between rich countries
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Types of Trade Protection

Explain, using a tariff diagram, the effects of imposing a tariff on imported goods on
different stakeholders, including domestic producers, foreign producers, consumers and
the government.

Explain, using a diagram, the effects of setting a quota on foreign producers on different
stakeholders, including domestic producers, foreign producers, consumers and the
government.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Types of Trade Protection

Explain, using a diagram, the effects of giving a subsidy to domestic producers on different
stakeholders, including domestic producers, foreign producers, consumers and the
government.

Describe administrative barriers that may be used as a means of protection.

Evaluate the effect of different types of trade protection.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Types of Trade Protection

Tariffs

Quotas

Voluntary Export Restraints (VERs)

Subsidies
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Types of Trade Protection

Administrative Barriers

Exchange Rates

Nationalistic Campaigns
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Arguments for and Against Trade Protection (arguments against and for free trade)

Discuss the arguments in favour of trade protection, including the protection of
domestic jobs, national security, protection of infant industries, the maintenance of
health, safety and environmental standards, anti-dumping and unfair competition, a
means of overcoming a balance of payments deficit and a source of government
revenue.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Arguments for and Against Trade Protection (arguments against and for free trade)

Discuss the arguments against trade protection, including a misallocation of
resources, the danger of retaliation and “trade wars”, the potential for corruption,
increased costs of production due to lack of competition, higher prices for domestic
consumers, increased costs of imported factors of production and reduced export
competitiveness.
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Arguments for Trade Protection (arguments against and for free trade)

To protect domestic employment

To protect sunrise or infant industries

To counteract relative domestic tax differences
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Arguments for Trade Protection (arguments against and for free trade)

To prevent dumping of foreign goods onto the domestic market

To diversify the production base of a developing country

To enforce product standards
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Arguments for Trade Protection (arguments against and for free trade)

To raise government revenue

To protect against unfairly low labor costs

To protect strategic industries
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Arguments for Trade Protection (arguments against and for free
trade)

To overcome a balance of payments deficit

To improve the terms of trade
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Arguments Against Trade Protection (arguments against and for free
trade)

Misallocation of resources

Escalation to a trade war

Protectionism as a corruption magnet
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Restrictions on Free Trade: Trade Protection
Arguments Against Trade Protection (arguments against and for free
trade)

Domestic complacency causes higher prices and costs

Higher import costs

Reduced export competitiveness
IB Economics SL: City Honors School
Unit 3: International Economics
3.1
International Trade
Theory of Knowledge: Potential Connections
Are there moral as well as economic arguments in favor of free
trade?
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates

Explain that the value of an exchange rate in a floating system is
determined by the demand for, and supply of, a currency.

Draw a diagram to show determination of exchange rates in a
floating exchange rate system.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates*
Forex Market (Foreign Exchange)

The Forex market is an international over-the-counter market (OTC). It
means that it is a decentralized, self-regulated market with no central
exchange or clearing house, unlike stocks and futures markets. This
structure eliminates fees for exchange and clearing, thereby reducing
transaction costs.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates*
Forex Market (Foreign Exchange)

The Forex OTC market is formed by different participants – with
varying needs and interests – that trade directly with each other.
These participants can be divided in two groups: the interbank
market and the retail market.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates: Forex Market
The Interbank Market
The interbank market designates Forex transactions that occur
between central banks, commercial banks and financial
institutions.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates: Forex Market The Interbank
Market

Central Banks - National central banks (such as the US Fed and the ECB) play
an important role in the Forex market. As principal monetary authority, their
role consists in achieving price stability and economic growth. To do so, they
regulate the entire money supply in the economy by setting interest rates
and reserve requirements. They also manage the country's foreign exchange
reserves that they can use in order to influence market conditions and
exchange rates.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates: Forex Market The Interbank
Market

Commercial Banks - Commercial banks (such as Deutsche Bank and Barclays) provide liquidity
to the Forex market due to the trading volume they handle every day. Some of this trading
represents foreign currency conversions on behalf of customers' needs while some is carried
out by the banks' proprietary trading desk for speculative purpose.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates: Forex Market The
Interbank Market

Financial Institutions - Financial institutions such as money managers,
investment funds, pension funds and brokerage companies trade foreign
currencies as part of their obligations to seek the best investment opportunities
for their clients. For example, a manager of an international equity portfolio will
have to engage in currency trading in order to buy and sell foreign stocks.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates: Forex Market
The Retail Market

Individuals - Individual traders or investors trade Forex on their own capital in
order to profit from speculation on future exchange rates. They mainly operate
through Forex platforms that offer tight spreads, immediate execution and
highly leveraged margin accounts.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates: Forex Market The
Retail Market

Speculation/Hedge Funds - Hedge funds are private investment funds that speculate in
various assets classes using leverage. Macro Hedge Funds pursue trading opportunities in
the Forex Market. They design and execute trades after conducting a macroeconomic
analysis that reviews the challenges affecting a country and its currency. Due to their large
amounts of liquidity and their aggressive strategies, they are a major contributor to the
dynamic of Forex Market. (Remember George Soros?)
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates: Forex Market
The Retail Market

Remittance Companies/Corporations - They represent the companies that are
engaged in import/export activities with foreign counterparts. Their primary
business requires them to purchase and sell foreign currencies in exchange for
goods, exposing them to currency risks. Through the Forex market, they convert
currencies and hedge themselves against future fluctuations.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determination of freely floating exchange rates: Forex Market
The Retail Market

Individuals - Individual traders or investors trade Forex on their own capital in
order to profit from speculation on future exchange rates. They mainly operate
through Forex platforms that offer tight spreads, immediate execution and
highly leveraged margin accounts.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Causes of Changes in the Exchange Rate

Describe the factors that lead to changes in currency demand and
supply, including foreign demand for a country’s exports, domestic
demand for imports, relative interest rates, relative inflation rates,
investment from overseas in a country’s firms (foreign direct
investment and portfolio investment) and speculation.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Causes of Changes in the Exchange Rate*

A country's exchange rate regime where its currency is set by the
foreign-exchange market through supply and demand for that
particular currency relative to other currencies. Thus, floating
exchange rates change freely and are determined by trading in the
forex market. This is in contrast to a "fixed exchange rate" regime.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Causes of Changes in the Exchange Rate*

In some instances, if a currency value moves in any one direction at a
rapid and sustained rate, central banks intervene by buying and
selling its own currency reserves (i.e. Federal Reserve in the U.S. &
ECB in the EU) in the foreign-exchange market in order to stabilize the
local currency. However, central banks are reluctant to intervene,
unless absolutely necessary, in a floating regime.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange
Rates
Causes of Changes in the
Exchange Rate*
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Causes of Changes in the Exchange Rate

Distinguish between a depreciation of the currency and an
appreciation of the currency.

Draw diagrams to show changes in the demand for, and supply of, a
currency.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Appreciation: An increase in the exchange rate.

The home currency becomes relatively more expensive for
foreigners to buy. Appreciation also means that foreign
currency becomes relatively cheaper for you to buy.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Appreciation: An increase in the exchange rate.

If prices in both countries remain the same, an appreciation will make foreign goods
relatively cheaper to you, leading to an increase in imports. It also means that, even
if prices remain the same, your goods will be more expensive to foreigners. They will
buy less of your goods and exports will fall. As a result, your country's net exports
will fall.

This change to net exports causes a leftward shift of the aggregate demand curve.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating
Exchange Rates
Appreciation: Figure
2a Demand Increase
2b Supply Decrease
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Depreciation: A decrease in the exchange rate.

The home currency becomes relatively cheaper for foreigners to buy.
Depreciation also means that foreign currency becomes relatively more
expensive for you to buy.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Depreciation: A decrease in the exchange rate.

If prices in both countries remain the same, depreciation will make foreign goods
relatively more expensive to you, leading to a fall in imports. It also means that, even if
prices remain the same, your goods will be cheaper to foreigners. They will buy more of
your goods and exports will rise. As a result, your country's net exports will increase.

This change to net exports causes a rightward shift of the aggregate demand curve.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating
Exchange Rates
Depreciation: Figure
3a Demand Decrease
3b Supply Increase
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
The effects of Exchange Rate Changes

Evaluate the possible economic consequences of a change in
the value of a currency, including the effects on a country’s
inflation rate, employment, economic growth and current
account balance.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Determinants of Exchange Rates:

Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative, and
are expressed as a comparison of the currencies of two countries.

The following are some of the principal determinants of the exchange rate
between two countries. Note that these factors are in no particular order; like
many aspects of economics, the relative importance of these factors is subject to
much debate.:
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Determinants of Exchange Rates
Demand for Goods and Services:

The relative demand for imports can directly influence the purchase
of currencies, and so alter the exchange rate. When the demand for a
country’s exports increases it increases demand for the currency
itself. To buy the exports, the importers first need to buy the
exporting country’s currency to pay for them.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Determinants of Exchange Rates
Demand for Foreign Direct Investment:

Foreign investors may find it necessary to to buy foreign currency to
make particular kinds of investment in that country. To make any kind
of significant foreign direct investment (FDI) by opening a branch
location, starting a new firm, or creating a joint venture in another
country, requires that country’s currency to buy the factors of
production (land, labor & capital).
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Determinants of Exchange Rates
Demand for Financial Investments and Capital Flows:

Financial investment such as buying of foreign company shares, or
interest-earning deposits in a foreign bank, are likely to require
purchase of the home currency. In other words, demand for a
country’s financial investments appreciates a currency.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Determinants of Exchange Rates
Relative Inflation Rates:

As the prices of one country rise faster than those of another,
its exports become more expensive and therefore, less
desirable. At the same time, imports will be relatively cheaper
than before and more attractive.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Determinants of Exchange Rates
Speculation:

The holders of foreign currencies can also speculate on future values.
As with the buying and selling of shares, speculators may buy a
currency hoping it will appreciate, sell it when they believe it has
reached peak value, and taking the resulting profits.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Determinants of Exchange Rates
Central Bank Intervention on the Forex Market:

The Central Banks may buy or sell large amounts of foreign
exchange with several goals in mind. They may seek to prop up
the value of their currency by using foreign currency reserves to
buy up their own.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Determinants of Exchange Rates
Central Bank Intervention on the Forex Market:

The Central Banks may also sell their own currency if they seek
to reduce its value, perhaps to increase the desirability of their
exports and reduce domestic consumption of imports.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Appreciation; Advantages to Appreciation:

Less expensive imports. The increased value of the currency
means that buying imported goods is now relatively less
expensive than before
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Appreciation; Advantages to Appreciation:

Competitive pressure on domestic exporters: An indirect effect of the
higher exchange rate is that domestic firms exporting to other
countries are at a price disadvantage relative to their foreign
competitors. As the exchange rate adjusted price of their exports
rises, they are compelled to seek out new ways of cutting costs and
innovating.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Appreciation; Disadvantages to Appreciation:

Exporter levels reduced: The distinction between pressure and
competitive disadvantage is blurred, and companies attempting to
export at consistently high exchange rates may come to believe that
while their import cost are low, it may not compensate for the
challenge of selling at the higher exchange rate.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Appreciation; Disadvantages to Appreciation:

Greater imports hurt domestic production: Relatively cheap imports
may hurt even non-exporting domestic industries. Those industries
cannot match the exchange rate discount now available on imported
goods. This could also result in unemployment in those industries
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Appreciation; Effects on Major Goals:

To Summarize, appreciation reduces inflationary pressure where the
demand for imports is relatively inelastic (e.g. energy resources). This
may eventually help with economic growth. The more immediate
impact on growth is to reduce exports and decrease real GDP.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Appreciation; Effects on Major Goals:

The trade balance of exports to imports is likely to move
towards a deficit, as exports slow down and cheaper imports
increase.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Depreciation; Advantages to Depreciation:

Expansion of Domestic Industries: Foreign consumers view
exports as relatively cheap, and are unlikely to import more.
This raises revenues in those exporting companies and could
increase employment.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Depreciation; Disadvantages to Depreciation:

Imported Inflation: Where countries need to import significant
levels of raw materials or resources, a decrease in the exchange
rate can bring on a certain amount of imported inflation.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates: Effects of Exchange Rates
Depreciation; Effects on Major Goals:

To Summarize, appreciation increase inflationary pressure where the
demand for imports is relatively inelastic (e.g. energy resources). This
may slow down economic growth. The more immediate impact on
growth is to increase exports and increase real GDP.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Government Intervention
Fixed Exchange Rates

Describe a fixed exchange rate system involving commitment to a single fixed rate.

Distinguish between a devaluation of a currency and a revaluation of a currency.

Explain, using a diagram, how a fixed exchange rate is maintained.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2 Exchange rates
Freely Floating Exchange Rates
Government Intervention: Fixed Exchange Rates

In a fixed exchange rate system, most of the transactions of one currency for
another will take place in the private market among individuals, businesses, and
international banks. However, by fixing the exchange rate the government would
have declared illegal any transactions that do not occur at the announced rate.
However, it is very unlikely that the announced fixed exchange rate will at all
times equalize private demand for foreign currency with private supply.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2 Exchange rates
Freely Floating Exchange Rates
Government Intervention: Fixed Exchange Rates

In a floating exchange rate system, the exchange rate adjusts to maintain the
supply and demand balance. In a fixed exchange rate system, it becomes the
responsibility of the central bank to maintain this balance.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2 Exchange rates
Freely Floating Exchange Rates
Government Intervention: Fixed Exchange Rates

In a floating exchange rate system, the exchange rate adjusts to maintain the
supply and demand balance. In a fixed exchange rate system, it becomes the
responsibility of the central bank to maintain this balance.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Government Intervention: Fixed Exchange Rates

For example, the United States fixes its currency to the British pound (the reserve), when there
is excess demand for pounds in exchange for U.S. dollars on the private Forex, the U.S. central
bank would immediately satisfy the excess demand by supplying additional pounds to the Forex
market. By doing so, it can maintain a credible fixed exchange rate.

For example, the United States fixes its currency to the British pound (the reserve), when there
is excess demand for dollars in exchange for British pounds on the private Forex, the U.S.
central bank would immediately satisfy the excess demand by supplying dollars to the Forex
market. By doing so, it can maintain a credible fixed exchange rate.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Government Intervention:
Fixed Exchange Rates
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Managed Exchange Rates (Managed Float)

Explain how a managed exchange rate operates, with reference to
the fact that there is a periodic government intervention to influence
the value of an exchange rate.

Examine the possible consequences of overvalued and undervalued
currencies.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Managed Exchange Rates (Managed Float)

A managed float exchange rate system is an international financial arrangement,
whereby central banks intervene only periodically, not necessarily to support a
country's currency, but rather to stabilize volatile fluctuations in foreign
exchange rates. A managed float is some times called a "dirty float" because
exchange rates are free to fluctuate, but central banks are committed to
intervene under conditions of perceived instability. The central bank steps in to
offset only so much of a change in demand or supply to bring the exchange rate
back into an acceptable "band" or range of exchange rates.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Managed Exchange Rates (Managed Float): Advantages

The managed float attempts to combine the advantages of both the fixed and flexible
exchange rate systems, depending on the degree of instability. The less instability, the less
intervention is necessary by central banks and they can pursue quasi-independent
domestic monetary policies to stabilize their own economies. The greater the instability,
the more intervention is necessary by central banks and the less free they are to pursue
independent domestic monetary policies because they are frequently required to use
their money supplies to calm disturbances in the foreign exchange markets.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Managed Exchange Rates (Managed Float): Disadvantages

The big problem with a managed float comes in determining the timing and magnitude of
the instability and the necessary intervention. Does a one day drop (rise) in a currency
warrant intervention? A week? A month? A year? Five years? Is a 1% drop (rise) in a
currency's exchange rate destabilizing? A 2% change? A 5% change? A 10% change? If the
central banks are too quick to respond or if the amount of intervention is inappropriate,
their actions may be further destabilizing. This increased instability has a tendency to
dampen international flows and contract world trade. If they wait too long, permanent
damage may be done to some countries' trade and investment balances.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Freely Floating Exchange Rates
Evaluation of Different Exchange Rate Systems (HL Only)

Compare and contrast a fixed exchange rate system with a floating
exchange rate system, with reference to factors including the degree
of certainty for stakeholders, ease of adjustment, the role of
international reserves in the form of foreign currencies and flexibility
offered to policy makers.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Current Account Deficits
The Relationship Between the Current Account and the Exchange
Rate (HL Only)

Explain why a deficit in the current account of the balance of
payments may result in downward pressure on the exchange
rate of the currency.
IB Economics SL: City Honors School
Unit 3: International Economics
3.2
Exchange rates
Current Account Surpluses
The Relationship Between the Current Account and the Exchange
Rate (HL Only)

Explain why a surplus in the current account of the balance of
payments may result in upward pressure on the exchange rate
of the currency.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments

Outline the role of the balance of payments.

Distinguish between debit items and credit items in the balance
of payments.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments

A statement that summarizes an economy’s transactions with the
rest of the world for a specified time period. The balance of
payments, also known as balance of international payments,
encompasses all transactions between a country’s residents and its
nonresidents involving goods, services and income; financial claims
on and liabilities to the rest of the world; and transfers such as gifts.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments

The balance of payments classifies these transactions in two accounts – the
current account and the capital account. The current account includes
transactions in goods, services, investment income and current transfers,
while the capital account mainly includes transactions in financial
instruments. An economy’s balance of payments transactions and
international investment position (IIP) together constitute its set of
international accounts.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments
The Current Account

The current account is used to mark the inflow and outflow of goods and
services into a country. Earnings on investments, both public and private,
are also put into the current account.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments

Within the current account are credits and debits on the trade of merchandise, which
includes goods such as raw materials and manufactured goods that are bought, sold or
given away (possibly in the form of aid). Services refer to receipts from tourism,
transportation (like the levy that must be paid in Egypt when a ship passes through the
Suez Canal), engineering, business service fees (from lawyers or management consulting,
for example) and royalties from patents and copyrights. When combined, goods and
services together make up a country's balance of trade (BOT).
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments

The BOT is typically the biggest bulk of a country's balance of payments as it
makes up total imports and exports. If a country has a balance of trade
deficit, it imports more than it exports, and if it has a balance of trade
surplus, it exports more than it imports.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments
The Capital Account

The capital account is where all international capital transfers are recorded. This
refers to the acquisition or disposal of non-financial assets (for example, a
physical asset such as land) and non-produced assets, which are needed for
production but have not been produced, like a mine used for the extraction of
diamonds.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments

The capital account is broken down into the monetary flows branching from
debt forgiveness, the transfer of goods, and financial assets by migrants leaving
or entering a country, the transfer of ownership on fixed assets (assets such as
equipment used in the production process to generate income), the transfer of
funds received to the sale or acquisition of fixed assets, gift and inheritance
taxes, death levies and, finally, uninsured damage to fixed assets.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Meaning of the Balance of Payments
The Financial Account

In the financial account, international monetary flows related to investment in business,
real estate, bonds and stocks are documented. Also included are government-owned
assets such as foreign reserves, gold, special drawing rights (SDRs) held with the
International Monetary Fund (IMF), private assets held abroad and direct foreign
investment. Assets owned by foreigners, private and official, are also recorded in the
financial account.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Components of the Balance of Payments Accounts

Explain the four components of the current account, specifically the
balance of trade in goods, the balance of trade in services, income
and current transfers.

Distinguish between a current account deficit and a current account
surplus.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Components of the Balance of Payments Accounts
The Current Account

The balance of the current account tells us if a country has a deficit or a surplus.
If there is a deficit, does that mean the economy is weak? Does a surplus
automatically mean that the economy is strong? Not necessarily. But to
understand the significance of this part of the BOP, we should start by looking at
the components of the current account: goods, services, income and current
transfers.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Components of the Balance of Payments Accounts
The Current Account

The Flow of Goods - These are movable and physical in nature, and in order for a
transaction to be recorded under "goods", a change of ownership from/to a resident (of
the local country) to/from a non-resident (in a foreign country) has to take place. Movable
goods include general merchandise, goods used for processing other goods, and nonmonetary gold. An export is marked as a credit (money coming in) and an import is noted
as a debit (money going out).
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Components of the Balance of Payments Accounts
The Current Account

The Flow of Services - These transactions result from an intangible action such as
transportation, business services, tourism, royalties or licensing. If money is being
paid for a service it is recorded like an import (a debit), and if money is received it is
recorded like an export (credit).
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Components of the Balance of Payments Accounts
The Current Account

The Flow of Income - Income is money going in (credit) or out (debit) of a country from
salaries, portfolio investments (in the form of dividends, for example), direct investments
or any other type of investment. Together, goods, services and income provide an
economy with fuel to function. This means that items under these categories are actual
resources that are transferred to and from a country for economic production.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Components of the Balance of Payments Accounts
The Current Account

The Flow of Transfers - Current transfers are unilateral transfers with nothing
received in return. These include workers' remittances, donations, aids and grants,
official assistance and pensions. Due to their nature, current transfers are not
considered real resources that affect economic production.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Components of the Balance of Payments Accounts

Explain the two components of the capital account, specifically capital
transfers and transaction in non-produced, non-financial assets.

Explain the three main components of the financial account, specifically,
direct investment, portfolio investment and reserve assets.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Relationships Between the Accounts

Explain that the current account balance is equal to the sum of the capital
account and financial account balances (see the appendix, “The balance of
payments”).

Examine how the current account and the financial account are
interdependent.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Relationships Between the Accounts

The current account should be balanced against the combined-capital and
financial accounts; however, as mentioned above, this rarely happens. We
should also note that, with fluctuating exchange rates, the change in the
value of money can add to BOP discrepancies. When there is a deficit in the
current account, which is a balance of trade deficit, the difference can be
borrowed or funded by the capital account.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Relationships Between the Accounts

If a country has a fixed asset abroad, this borrowed amount is marked as a capital account
outflow. However, the sale of that fixed asset would be considered a current account
inflow (earnings from investments). The current account deficit would thus be funded.
When a country has a current account deficit that is financed by the capital account, the
country is actually foregoing capital assets for more goods and services. If a country is
borrowing money to fund its current account deficit, this would appear as an inflow of
foreign capital in the BOP.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
The Structure of the Balance of Payments
The Relationships Between the Accounts

Explain that the current account balance is equal to the sum of the capital
account and financial account balances (see the appendix, “The balance of
payments”).

Examine how the current account and the financial account are
interdependent.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
Current Account Deficits
The Relationship Between the Current Account and the Exchange
Rate

Explain why a deficit in the current account of the balance of
payments may result in downward pressure on the exchange
rate of the currency.
IB Economics SL: City Honors School
Unit 3: International Economics
3.3
The Balance of Payments
Current Account Surpluses
The relationship between the current account and the exchange
rate

Explain why a surplus in the current account of the balance of
payments may result in upward pressure on the exchange rate
of the currency.
IB Economics SL: City Honors School
Unit 3: International Economics
3.4
Economic Integration
Forms of economic integration
Preferential trade agreements

Distinguish between bilateral and multilateral (WTO) trade
agreements.

Explain that preferential trade agreements give preferential
access to certain products from certain countries by reducing or
eliminating tariffs, or by other agreements relating to trade.
IB Economics SL: City Honors School
Unit 3: International Economics
3.4
Economic Integration
Forms of economic integration
Trading Blocs

Distinguish between a free trade area, a customs union and a common
market.

Explain that economic integration will increase competition among
producers within the trading bloc.

Compare and contrast the different types of trading blocs.
IB Economics SL: City Honors School
Unit 3: International Economics
3.4
Economic Integration
Forms of economic integration
Monetary Union

Explain that a monetary union is a common market with a common currency
and a common central bank.

Discuss the possible advantages and disadvantages of a monetary union for
its members.
IB Economics SL: City Honors School
Unit 3: International Economics
3.4
Economic Integration
Theory of Knowledge: Potential Connections
What criteria can be used to assess the benefits and the
costs of increased economic integration?
Might increased economic integration ever be
considered undesirable?