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Foreign Exchange
Market Shifts

How fiscal policy, monetary policy, and economic conditions move exchange rates through supply and demand.

AP Macroeconomics

What Is the Foreign Exchange Market?

The foreign exchange market (FOREX) is where national currencies are traded. The price of one currency expressed in terms of another is the exchange rate. For example, if \( 1 \text{ USD} = 110 \text{ JPY} \), the dollar's price in yen is 110.

Demand for a Currency
Foreign buyers need your currency to purchase your exports, invest in your assets, or hold as reserves.
Supply of a Currency
Domestic buyers supply your currency when they exchange it to purchase imports or invest abroad.

Exchange Rate Determination

Exchange Rate (e) Quantity of Currency D S \(Q^*\) \(e^*\)

Appreciation vs. Depreciation

Appreciation
A currency appreciates when its exchange rate rises: it buys more foreign currency. Caused by increased demand or decreased supply of the currency.
Depreciation
A currency depreciates when its exchange rate falls: it buys less foreign currency. Caused by decreased demand or increased supply of the currency.

What Shifts Currency Demand and Supply?

Relative Interest Rates
Higher real interest rates attract foreign financial capital, increasing demand for the currency.
Relative Income / GDP
Higher domestic income increases imports, raising supply of the domestic currency (depreciation).
Relative Price Levels
Higher domestic inflation makes exports expensive, reducing demand for the currency.

Core Rule: Interest Rates Drive Capital Flows

Real Interest Rates Rise Foreign Capital Flows In Demand for Currency Rises Currency Appreciates

Nominal vs. Real Interest Rate Effects

Nominal Rate Rises Real Rate Rises
Cause Could be inflation Tight monetary policy or strong growth
Capital Flows Not guaranteed Attracts foreign capital
Currency Effect Ambiguous Appreciation
AP Exam Tip Check if inflation rose too Directly shifts demand right

How Monetary Policy Affects FOREX

1
Central bank tightens money supply (contractionary monetary policy).
2
Domestic real interest rates rise as the money supply decreases.
3
Foreign investors seek higher returns, buying domestic financial assets.
4
Demand for the domestic currency rises on the FOREX market.
5
The domestic currency appreciates; the foreign currency depreciates.

How Fiscal Policy Affects FOREX

1
Government increases spending (expansionary fiscal policy) financed by borrowing.
2
Government borrowing increases demand for loanable funds, pushing real interest rates up (\( r \uparrow \)).
3
Higher real rates attract foreign capital → demand for the domestic currency increases.
4
Domestic currency appreciates, making exports more expensive and imports cheaper.
5
Net exports fall (\( NX \downarrow \)): this is the "crowding-out effect in the open economy."

Step-by-Step: Analyzing a FOREX Shift

1
Identify the change: Is it a policy (monetary, fiscal) or an economic condition (inflation, growth, tastes)?
2
Trace through interest rates: Does the change raise or lower real interest rates?
3
Determine capital flows: Higher \( r \) → capital inflow → demand for currency rises. Lower \( r \) → capital outflow → supply of currency rises.
4
Shift the correct curve in the FOREX graph (demand or supply) and find the new equilibrium.
5
State the result: appreciation or depreciation, and its downstream effects on net exports.

Example 1: Contractionary Monetary Policy

The Federal Reserve sells government bonds on the open market. Trace through the effect on the dollar in the FOREX market for U.S. dollars (priced in euros).

Exchange Rate (€/$) Quantity of Dollars D₁ D₂ S \(e_1\) \(e_2\)

Example 2: Expansionary Fiscal Policy

Congress passes a large infrastructure spending bill financed by borrowing. What happens to the dollar in the FOREX market?

1
Government borrows more → demand for loanable funds shifts right → \( r \uparrow \).
2
Higher real interest rates attract foreign investors → demand for dollars rises.
3
Dollar appreciates → U.S. exports become more expensive abroad → net exports decline (\( NX \downarrow \)).

Example 3: Inflation Differential

Suppose the U.S. experiences higher inflation than Japan. How does this affect the dollar/yen exchange rate?

Exchange Rate (¥/$) Quantity of Dollars D₁ D₂ S \(e_1\) \(e_2\)

Income Growth and Currency Markets

When a country's real GDP grows faster than its trading partners, its citizens buy more imports. To pay for those imports, they must exchange domestic currency for foreign currency.

Exchange Rate (e) Quantity of Currency D S₁ S₂ \(e_1\) \(e_2\)

Common Mistakes to Avoid

✕ Confusing Supply and Demand Curves
Capital inflow increases demand for the currency, not supply. Importing goods increases supply of the currency, not demand.
✕ Ignoring Which Currency Is Being Graphed
If the graph shows the market for dollars, then "demand for dollars" shifts. Do not accidentally shift supply when demand should move.
✕ Skipping the Interest Rate Step
Fiscal and monetary policies affect FOREX indirectly through interest rates. Always trace: policy → \( r \) → capital flow → FOREX.

Summary: Policies and FOREX Effects

Change Interest Rate Capital Flow Currency Effect
Contractionary Monetary \( r \uparrow \) Inflow Appreciates
Expansionary Monetary \( r \downarrow \) Outflow Depreciates
Expansionary Fiscal \( r \uparrow \) Inflow Appreciates
Contractionary Fiscal \( r \downarrow \) Outflow Depreciates
Higher Domestic Inflation Real \( r \downarrow \) Outflow Depreciates
Faster Domestic Growth Ambiguous Imports rise Depreciates

Question 1 of 5

If the European Central Bank raises interest rates, what happens to the euro in the FOREX market?

Question 2 of 5

The U.S. government enacts a large tax cut financed by borrowing. Which sequence correctly traces the effect on the dollar?

Question 3 of 5

Japan experiences a period of rapid economic growth while the U.S. economy grows slowly. In the market for yen (priced in dollars), which curve shifts?

Question 4 of 5

If the Federal Reserve conducts open market purchases of bonds, which of the following is true about the dollar?

Question 5 of 5

Country A has significantly higher inflation than Country B. What happens in the FOREX market for Country A's currency?