AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/6/6-3)
Unit 6 · Topic 6.3
6.3 The Foreign Exchange Market
The foreign exchange market is where people swap one currency for another, and supply and demand there set the exchange rate. Demand for a currency comes from people who want that country's goods, services and assets; supply comes from that country's own residents, who need other currencies to buy things abroad. Where the curves cross is the equilibrium exchange rate.
Key terms
- foreign exchange market
- demand for a currency
- supply of a currency
- equilibrium exchange rate
- currency surplus and shortage
Drawing the graph
Each foreign exchange graph shows the market for one currency. The vertical axis must show the price of one unit of the currency on the horizontal axis; getting these units upside down is a common labeling error. For the market for euros, traded for dollars:
- Vertical axis: dollars per euro. This is the exchange rate, the price of one euro.
- Horizontal axis: quantity of euros.
- Demand for euros (D): slopes downward.
- Supply of euros (S): slopes upward.
- Equilibrium: where they cross, at exchange rate e1 and quantity Q1.
- For the market for dollars instead, flip it: euros per dollar on the vertical axis and the quantity of dollars on the horizontal axis.
Where demand and supply come from
Demand for euros comes from anyone outside the euro area who wants to buy European goods, services or assets: an American buying an Italian handbag, a U.S. tourist in Paris, a U.S. fund buying German bonds. Each one needs euros to pay.
Supply of euros comes from people in the euro area who want to buy things priced in other currencies: a Spanish company buying U.S. computers, a French investor buying U.S. stocks. They offer euros in exchange for dollars.
Demand slopes down because a cheaper euro (fewer dollars per euro) makes European goods cheaper for Americans, so they want more euros. Supply slopes up because when each euro buys more dollars, U.S. goods look cheaper to Europeans, so they offer more euros.
Disequilibrium and adjustment
If the exchange rate is above e1, Europeans offer more euros than others want to buy: a surplus of euros. Sellers accept fewer dollars per euro, and the euro depreciates toward e1.
If the rate is below e1, more euros are wanted than offered: a shortage. Buyers bid up the price, and the euro appreciates toward e1.
Two markets, one trade
Every currency trade shows up in two markets. When Americans want more euros, they have to give up dollars to get them. So each change has a mirror image. On the exam, check which currency's market the question asks you to draw.
- Demand for euros increases ↔ supply of dollars increases.
- Supply of euros increases ↔ demand for dollars increases.
- The euro appreciates against the dollar ↔ the dollar depreciates against the euro.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
The market for the peso
Describe a correctly labeled graph of the foreign exchange market for the Mexican peso, traded for U.S. dollars, and say who demands and who supplies pesos.
Show the solutionHide the solution
- Step 1: Vertical axis: dollars per peso (the price of one peso). Horizontal axis: quantity of pesos.
- Step 2: Demand for pesos slopes downward. It comes from people outside Mexico, such as Americans, who want Mexican goods, services or assets and need pesos to pay.
- Step 3: Supply of pesos slopes upward. It comes from people in Mexico who want U.S. goods, services or assets and trade pesos for dollars to buy them.
- Step 4: Mark the equilibrium exchange rate e1 where the curves cross, and the quantity Q1.
Answer: Dollars per peso on the vertical axis, quantity of pesos on the horizontal axis, downward-sloping demand from foreign buyers of Mexican goods and assets, upward-sloping supply from Mexican buyers of foreign goods and assets, and equilibrium at e1 and Q1.
- Example 2
Surplus or shortage?
In the market for euros, at an exchange rate of $1.40 per euro, 120 billion euros are supplied and 80 billion are demanded. Is there a surplus or a shortage, and which way will the exchange rate move?
Show the solutionHide the solution
- Step 1: Quantity supplied (120 billion) is greater than quantity demanded (80 billion), so there's a surplus of 40 billion euros.
- Step 2: Sellers of euros accept fewer dollars per euro, so the exchange rate falls.
- Step 3: The euro depreciates and the dollar appreciates until quantity supplied equals quantity demanded.
Answer: A surplus of 40 billion euros; the rate falls, so the euro depreciates (and the dollar appreciates).
- Example 3
Same event, two graphs (classic trap)
U.S. consumers decide they want more European products. Show the effect in the market for euros and in the market for dollars.
Show the solutionHide the solution
- Step 1: Market for euros: Americans need more euros to buy European products, so demand for euros shifts right. The price of a euro in dollars rises: the euro appreciates.
- Step 2: Market for dollars: to get those euros, Americans offer more dollars, so the supply of dollars shifts right. The price of a dollar in euros falls: the dollar depreciates.
- Step 3: The trap is shifting the demand for dollars. Americans buying foreign goods supply dollars; they don't demand them.
Answer: Demand for euros shifts right (the euro appreciates); supply of dollars shifts right (the dollar depreciates).
Common mistakes
- Labeling the vertical axis 'price' or 'exchange rate' without units, or with the units upside down. In the market for euros, use dollars per euro.
- Shifting demand for the home currency when residents want more foreign goods. Buying foreign goods means supplying your own currency and demanding the foreign one.
- Treating a change in the exchange rate as a shift. A change in the rate is a movement along the curves; only outside factors shift them (6.4).
On the exam
- Free-response questions often ask for a correctly labeled graph of the foreign exchange market for a named currency and the effect of a change on its value. Label the axes with the right units, label demand and supply, and show the new equilibrium exchange rate.
- Multiple-choice questions may show both currencies' markets and ask which curves shift. Remember that the two markets mirror each other.
Connected topics
Videos
Check yourself
3 questions on 6.3 The Foreign Exchange Market. Pick an answer to see if you got it, and why.
In the foreign exchange market for U.S. dollars, with the price of a dollar in yen on the vertical axis, the supply of dollars comes from
Why does the demand curve for a country's currency slope downward in the foreign exchange market?
In the foreign exchange market for dollars, with euros per dollar on the vertical axis, the demand for dollars increases. In the market for euros, with dollars per euro on the vertical axis, what happens?
0 of 3 answered