AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/6/6-5)
Unit 6 · Topic 6.5
6.5 Changes in the Foreign Exchange Market and Net Exports
A change in a currency's value changes the prices foreigners pay for a country's exports and the prices its own residents pay for imports. When a currency appreciates, net exports fall and AD shifts left; when it depreciates, net exports rise and AD shifts right.
Key terms
- net exports
- exports
- imports
- appreciation
- depreciation
- aggregate demand
Why the exchange rate changes trade
Exports and imports are priced in different currencies. A $30,000 U.S.-made car costs a Japanese buyer ¥4,500,000 at 150 yen per dollar, but only ¥3,600,000 at 120 yen per dollar. So a weaker dollar makes U.S. exports cheaper abroad, and a stronger dollar makes them more expensive.
- Appreciation: exports fall because they cost more abroad, and imports rise because foreign goods cost less at home. Net exports decrease.
- Depreciation: exports rise and imports fall. Net exports increase.
From net exports to aggregate demand
Net exports (Xn) are part of aggregate demand: AD = C + I + G + Xn. So a change in the exchange rate shifts AD.
Example: if the euro depreciates against the dollar, the dollar has appreciated. European goods get cheaper for Americans, so U.S. imports rise and U.S. net exports fall, shifting U.S. AD left.
On an AD–AS graph (price level on the vertical axis, real GDP on the horizontal axis), a depreciation shifts AD1 right to AD2. Along the upward-sloping SRAS, the new short-run equilibrium has a higher price level and higher real GDP. An appreciation shifts AD left, lowering both.
- Depreciation: Xn rises, so AD shifts right. In the short run, real GDP and the price level rise and unemployment falls.
- Appreciation: Xn falls, so AD shifts left. In the short run, real GDP and the price level fall and unemployment rises.
How this changes policy's effects
The trade link strengthens monetary policy. Expansionary monetary policy lowers interest rates, which raises investment, and also depreciates the currency, which raises net exports. Both push AD to the right.
The trade link weakens fiscal policy that's paid for by borrowing. Expansionary fiscal policy can raise real interest rates and make the currency appreciate, which lowers net exports and offsets part of the increase in AD.
A currency's value also helps some groups and hurts others. A strong dollar is good for U.S. tourists abroad and for firms that import, and hard on U.S. exporters. A weak dollar does the reverse.
Net exports and the current account
Net exports are usually the biggest part of the current account (6.1). So a depreciation tends to move the current account toward a surplus (or a smaller deficit), and an appreciation tends to move it toward a deficit.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
From the exchange rate to AD
The exchange rate moves from 150 yen per dollar to 120 yen per dollar. (a) Did the dollar appreciate or depreciate? (b) What happens to the yen price of a $30,000 U.S.-made car? (c) What happens to U.S. net exports and U.S. AD?
Show the solutionHide the solution
- Step 1: (a) Each dollar now buys fewer yen, so the dollar depreciated.
- Step 2: (b) Before: $30,000 × 150 = ¥4,500,000. After: $30,000 × 120 = ¥3,600,000. The car is cheaper for Japanese buyers.
- Step 3: (c) U.S. exports to Japan rise. Japanese goods cost more dollars, so U.S. imports from Japan fall. Net exports increase, so U.S. AD shifts right.
Answer: (a) The dollar depreciated. (b) The price falls from ¥4,500,000 to ¥3,600,000. (c) U.S. net exports rise and AD shifts right.
- Example 2
A stronger dollar
The U.S. dollar appreciates against the currencies of its trading partners. Explain the short-run effects on U.S. exports, imports, net exports, AD, real GDP and unemployment.
Show the solutionHide the solution
- Step 1: U.S. goods now cost more in foreign currencies, so U.S. exports fall.
- Step 2: Foreign goods now cost fewer dollars, so U.S. imports rise.
- Step 3: With exports down and imports up, net exports fall.
- Step 4: Net exports are part of AD, so AD shifts left. In the short run, real GDP falls and unemployment rises (and the price level falls).
Answer: Exports fall, imports rise, net exports fall, AD decreases, real GDP falls and unemployment rises.
- Example 3
Whose net exports? (classic trap)
The Mexican peso depreciates against the U.S. dollar. What happens to Mexico's net exports, and to U.S. net exports with Mexico?
Show the solutionHide the solution
- Step 1: A cheaper peso makes Mexican goods cheaper for Americans, so Mexico's exports rise.
- Step 2: U.S. goods now cost more pesos, so Mexico's imports from the U.S. fall. Mexico's net exports increase.
- Step 3: The other side of the same change: the dollar appreciated against the peso, so U.S. exports to Mexico fall and imports from Mexico rise. U.S. net exports with Mexico decrease.
- Step 4: The trap is giving both countries the same result. When one currency depreciates, that country's net exports rise and its partner's fall.
Answer: Mexico's net exports rise; U.S. net exports with Mexico fall.
Common mistakes
- Saying a stronger currency raises exports. Appreciation makes exports more expensive for foreigners, so exports fall.
- Stopping at net exports. Many questions want the next steps: net exports change, so AD shifts, so real GDP, the price level and employment change.
- Mixing up which country gains. When one currency depreciates, that country's net exports rise and its trading partner's fall.
On the exam
- Free-response questions often say a currency appreciates (or depreciates) and ask what happens to net exports and to AD or real GDP. Give the direction and the reason for each.
- Expect these effects at the end of long questions that start in the money market, the reserve market or the loanable funds market.
Connected topics
Videos
Check yourself
4 questions on 6.5 Changes in the Foreign Exchange Market and Net Exports. Pick an answer to see if you got it, and why.
If the U.S. dollar appreciates against other currencies, what happens to U.S. net exports and aggregate demand, all else equal?
Country K's currency depreciates sharply against the currencies of its trading partners. In the short run, what is the most likely effect on Country K's real GDP and price level?
A U.S. company sells software for $100. The exchange rate changes from 0.90 euros per dollar to 1.00 euro per dollar. What happens to the software's price for buyers in Europe, and what is the likely effect on U.S. software exports?
If the dollar depreciates against the euro, which of the following is most likely?
0 of 4 answered