AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/6/6-4)
Unit 6 · Topic 6.4
6.4 Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market
Anything that changes how much people want a country's goods, services or assets shifts the demand for or supply of its currency. Tastes, relative incomes, relative price levels, relative interest rates and trade barriers all matter. Fiscal and monetary policy change exchange rates by working through these factors.
Key terms
- shifters of currency demand
- shifters of currency supply
- relative interest rates
- relative price levels
- relative incomes
- tariffs and quotas
The shifters
Each row shows one change in the U.S., with everything else held constant, and its effect in the foreign exchange market for dollars.
| Change in the U.S. | Effect in the market for dollars | The dollar |
|---|---|---|
| Foreigners come to like U.S. goods more | Demand for dollars increases | Appreciates |
| U.S. incomes rise faster than incomes abroad | Americans buy more imports, so the supply of dollars increases | Depreciates |
| The U.S. price level rises relative to other countries | U.S. goods cost more abroad, so demand falls; imports look cheaper, so supply rises | Depreciates |
| U.S. real interest rates rise relative to other countries | Foreigners want more U.S. assets, so demand rises; Americans buy fewer foreign assets, so supply falls | Appreciates |
| The U.S. puts a tariff or quota on imports | Americans buy fewer imports, so the supply of dollars decreases | Appreciates |
| Investors expect the dollar to rise in the future | Demand for dollars increases now | Appreciates |
Monetary policy and the exchange rate
Expansionary monetary policy lowers interest rates at home. Domestic bonds and deposits now pay less than foreign ones, so foreign investors demand less of the home currency and domestic investors supply more of it to buy foreign assets. The currency depreciates. Contractionary policy raises interest rates and makes the currency appreciate.
In the short run, economists assume expected inflation doesn't change, so a lower nominal interest rate also means a lower real interest rate. That's why the real-interest-rate shifter applies.
Fiscal policy and the exchange rate
Expansionary fiscal policy paid for by borrowing tends to raise the real interest rate (5.5). Higher real rates attract foreign financial capital, which raises the demand for the home currency, so it appreciates. Contractionary fiscal policy that shrinks the deficit tends to lower real rates and make the currency depreciate.
Fiscal policy also changes incomes and the price level, which affect imports. When a question asks how a deficit affects the currency, explain the interest rate path step by step.
A central bank trading its own currency
A central bank can also trade directly in the foreign exchange market. If it buys its own currency (paying with foreign currency it holds), demand for its currency rises and the currency appreciates. If it sells its own currency, supply rises and the currency depreciates.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Interest rates and the dollar
The Federal Reserve raises interest on reserves, and U.S. interest rates rise relative to Canada's. Show the effect on the foreign exchange market for U.S. dollars and on the dollar's value.
Show the solutionHide the solution
- Step 1: Draw the market for dollars: Canadian dollars per U.S. dollar on the vertical axis, quantity of U.S. dollars on the horizontal axis, demand D1 and supply S1 crossing at e1.
- Step 2: Expected inflation doesn't change right away, so U.S. real interest rates rise too. U.S. assets now pay relatively more, so Canadian investors want more U.S. assets and need more U.S. dollars to buy them. Demand shifts right from D1 to D2.
- Step 3: The new equilibrium exchange rate, e2, is higher: each U.S. dollar buys more Canadian dollars.
- Step 4: (Americans also have less reason to buy Canadian assets, which shifts the supply of U.S. dollars left and pushes the same way.)
Answer: Demand for U.S. dollars increases, the exchange rate rises from e1 to e2, and the dollar appreciates.
- Example 2
A tariff
Country A puts a tariff on imports from Country B. What happens to the supply of Country A's currency and to its value against Country B's currency?
Show the solutionHide the solution
- Step 1: The tariff makes B's goods more expensive in A, so A's residents buy fewer of them.
- Step 2: With fewer imports to pay for, A's residents need less of B's currency, so they supply less of A's currency in the foreign exchange market.
- Step 3: The supply of A's currency shifts left, so its price in B's currency rises.
Answer: The supply of A's currency decreases, and A's currency appreciates against B's.
- Example 3
Higher inflation at home (classic trap)
Inflation in the United Kingdom becomes higher than inflation in the U.S. A student says the British pound appreciates 'because prices are higher.' What actually happens to the pound?
Show the solutionHide the solution
- Step 1: Higher U.K. prices make British goods more expensive for Americans, so Americans buy fewer of them and demand fewer pounds. Demand for pounds shifts left.
- Step 2: U.S. goods now look cheaper to British buyers, so they buy more of them and supply more pounds to get dollars. Supply of pounds shifts right.
- Step 3: Both shifts lower the pound's price in dollars.
Answer: The pound depreciates against the dollar.
Common mistakes
- Thinking higher inflation at home makes the currency stronger. A relatively higher price level makes the currency depreciate.
- Shifting the demand for the home currency after a tariff at home. A home tariff reduces imports, so it reduces the supply of the home currency.
- Leaving out the interest rate step. Write the full chain: the policy changes the interest rate, so financial capital flows change, so demand for or supply of the currency changes, so the exchange rate changes.
On the exam
- Free-response questions often say a policy changed interest rates and ask what happens to the demand for or supply of a currency and to its value. Name the curve that shifts and the direction.
- Long questions often connect the money market or reserve market to the foreign exchange market. Carry the interest rate change through to capital flows and then to the currency.
Connected topics
Videos
Check yourself
4 questions on 6.4 Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market. Pick an answer to see if you got it, and why.
U.S. real incomes rise rapidly, while incomes in Mexico stay the same. In the foreign exchange market for dollars (pesos per dollar on the vertical axis), what is the most likely effect?
The U.S. price level rises faster than Canada's. All else equal, what happens to the U.S. dollar relative to the Canadian dollar?
Consumers in Europe develop a strong preference for jeans made in the United States. What is the most likely effect on the dollar?
Country A places a tariff on goods imported from Country B, so Country A's residents buy fewer of Country B's goods. Both countries have flexible exchange rates. What is the most likely effect on Country A's currency?
0 of 4 answered