Three practice questions are below. Answer on the page: each one is marked the moment you pick, the correct option is shown whether or not you found it, and the full explanation opens either way.
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Exchange Rates: three questions to try now
Real questions, the answer key from the mark scheme, and the explanation that goes with it. No account needed to answer them.
Cross-board concept practice · originally a CIE 9708 question, used here because the concept is the same. It is not IB Economics past-paper material.
Question 1
Why might a government wish to increase the value of its foreign exchange rate when the sum of the price elasticity of demand for imports and exports is greater than 1?
Answer: D.
A stronger currency makes everything bought from abroad cheaper in domestic money, so imported raw materials cost firms less, that benefit holds whatever the elasticities are, which is why D is the answer. The elasticity condition in the question is there to steer you away from B. When the price elasticities of demand for imports and exports sum to more than one, the Marshall-Lerner condition is met, and that means a change in the exchange rate moves the current account in the familiar direction, so an APPRECIATION would WORSEN the current account, not improve it. A also points the wrong way, since a dearer currency makes the country more expensive for tourists and deters them. C is wrong because a stronger currency lowers import prices and so dampens inflation rather than raising it.
Cross-board concept practice · originally a CIE 9708 question, used here because the concept is the same. It is not IB Economics past-paper material.
Question 2
Following a long period of depreciation of the US$, both the US and UK monetary authorities raised their domestic interest rate. What will happen to the value of the exchange rate of the US$ in terms of UK£?
Answer: D.
An exchange rate responds to the DIFFERENCE in returns between two countries, not to the level of rates in either one. Money flows towards whichever currency now offers the better deal. Here both the United States and the United Kingdom raised their interest rates, and the question never says by how much. If the American rise is larger, dollars become relatively more attractive and the dollar strengthens; if the British rise is larger, it weakens; if the two rises match, the differential is unchanged and so, other things equal, is the rate. With the sizes unknown the direction genuinely cannot be determined, so D is the honest answer. The earlier depreciation of the dollar is background and does not settle what happens next.
Cross-board concept practice · originally a CIE 9708 question, used here because the concept is the same. It is not IB Economics past-paper material.
Question 3
A country has a floating exchange rate. An increase in which variable within that country can cause its exchange rate to appreciate?
Answer: C.
Under a floating rate the currency appreciates when foreigners want more of it than domestic residents are supplying to the market. A rise in interest rates achieves that by making financial assets in the country more attractive, so overseas investors buy the currency to acquire them and demand for it climbs. Rising domestic income levels pull in the opposite direction, because higher incomes mean more spending and a good part of that goes on imported goods, which requires selling domestic currency to pay foreign suppliers. A rise in employment works through the same channel, since more people earning means more imports bought, so it weakens rather than strengthens the currency. A rise in the domestic price level is the most clearly damaging of the three, as it makes exports less competitive abroad and imports better value at home, reducing demand for the currency while increasing its supply.
These questions are drawn from past Cambridge papers, mapped across to this topic because the concept is the same. You answer, you find out immediately whether you were right, and you get the reasoning for the correct option and for each distractor. Wrong answers go to a mistakes locker so you can come back to exactly those.
Practice is free. You need an account only so your progress and your mistakes are still there next time.
These are the errors that cost marks on exchange rates, taken from our own topic notes. Read them before you practise and you will recognise the traps in the questions.
Using "devaluation" for a market-driven fall; that is a depreciation.
Assuming a depreciation always improves the current account. It depends on elasticities (Marshall–Lerner) and on the time frame (J-curve).
Forgetting that a depreciation raises imported input costs for domestic firms, so exporters are not simply winners.
Mislabelling the axes, or not stating which currency the market is for.
Ignoring supply-side capacity: cheaper exports achieve nothing if firms cannot produce more.
Treating exchange-rate changes as affecting only trade, and forgetting foreign-currency debt.