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Foreign Exchange Market
and Net Exports

Understand how currency appreciation and depreciation affect trade flows, and master the link between the foreign exchange market and a nation's net exports.

AP Macroeconomics

What Is the Foreign Exchange Market?

The foreign exchange market (FOREX) is where currencies are bought and sold. Every international transaction: buying a Japanese car, investing in British bonds, or touring France: requires exchanging one currency for another.

Exchange Rate
The price of one currency in terms of another, e.g. \(1\;\text{USD} = 0.92\;\text{EUR}\)
Supply & Demand
Exchange rates are determined by the supply of and demand for currencies in FOREX

Key Terms You Need to Know

Appreciation
A currency increases in value: it can buy more foreign currency per unit
Depreciation
A currency decreases in value: it buys less foreign currency per unit
Net Exports
\(NX = \text{Exports} - \text{Imports}\). Positive = trade surplus, negative = trade deficit

Why Exchange Rates Matter for Trade

Exchange rate changes directly affect the relative prices of domestic and foreign goods. When prices shift, consumers and firms change their buying patterns: this is the mechanism linking FOREX to net exports.

The Core Rule: Currency Value and Trade

USD Appreciates US goods cost more for foreigners Foreign goods cost less for Americans
\(\text{Exports} \downarrow, \text{Imports} \uparrow\)
\(NX\) decreases
 USD Depreciates US goods cost less for foreigners Foreign goods cost more for Americans
\(\text{Exports} \uparrow, \text{Imports} \downarrow\)
\(NX\) increases

Supply and Demand in the FOREX Market

Quantity of USD Exchange Rate (\(e\))
\(D_{\$}\)
\(S_{\$}\)
\(Q^*\)
\(e^*\)

What Shifts Demand for a Currency?

1
Foreign demand for domestic goods: If foreigners want more US products, demand for USD increases.
2
Relative interest rates: Higher US interest rates attract foreign investment → demand for USD rises.
3
Relative price levels: Lower US inflation makes US goods cheaper → demand for USD rises.
4
Speculation: If investors expect the USD to appreciate, they buy USD now → demand increases.

Appreciation vs. Depreciation

Appreciation Depreciation
Currency Value Increases Decreases
Exchange Rate (\(e\)) Rises Falls
Domestic Goods for Foreigners More expensive Less expensive
Foreign Goods for Domestic Buyers Less expensive More expensive
Exports Decrease Increase
Imports Increase Decrease
Net Exports (\(NX\)) Decrease Increase

How to Trace the Chain of Reasoning

1
Identify the shock: What changed? (Interest rates, price levels, tastes, speculation, income)
2
Determine which curve shifts: Does demand for or supply of the currency change? Which direction?
3
Find the new exchange rate: Does the currency appreciate or depreciate?
4
Link to trade: Appreciation → \(NX\) falls. Depreciation → \(NX\) rises.
5
Connect to AD: Changes in \(NX\) shift aggregate demand: \(\Delta NX > 0\) → \(AD\) shifts right; \(\Delta NX < 0\) → \(AD\) shifts left.

Example 1: US Interest Rates Rise

Suppose the Federal Reserve raises the federal funds rate. Foreign investors now find US bonds more attractive, so they need USD to invest in the US.

Quantity of USD Exchange Rate
\(S_{\$}\)
\(D_1\)
\(D_2\)
\(e_1\)
\(e_2\)
 Shift

Example 2: US Inflation Rises

Suppose the US experiences higher inflation relative to its trading partners. US goods become relatively more expensive, so foreign demand for US goods falls.

Quantity of USD Exchange Rate
\(S_{\$}\)
\(D_1\)
\(D_2\)
\(e_1\)
\(e_2\)
 Shift

Example 3: A Two-Country Scenario

Japan's central bank raises interest rates while the US holds steady. How does this affect the USD/JPY exchange rate and US net exports?

1
Shock: Japanese interest rates rise relative to US rates.
2
Curve shift: US investors want Japanese bonds → supply of USD increases (to buy yen). Meanwhile, Japanese investors find US bonds less attractive → demand for USD decreases.
3
Exchange rate: USD depreciates (fewer yen per dollar).
4
Trade effect: US goods become cheaper for Japanese buyers → US exports rise. Japanese goods become more expensive for Americans → US imports fall.
5
Result: \(NX\) increases → \(AD\) shifts right.

The Interest Rate ↔ Exchange Rate Link

\(\text{Interest Rate} \uparrow\)
\(\text{Capital Inflow} \uparrow\)
\(\text{Demand for } \$ \uparrow\)
\(\$ \text{ Appreciates}\)
\(NX\) Decreases

Determinants of Exchange Rates

Relative Interest Rates
Higher rates attract foreign capital, increasing demand for the currency
Relative Price Levels
Lower inflation makes goods cheaper, increasing demand for the currency
Relative Income
Higher domestic income increases imports, raising supply of the currency (depreciation)
Speculation
Expected future appreciation increases current demand for the currency

Common Mistakes to Avoid

✕ Reversing the Direction
Appreciation does NOT help exports. A stronger dollar makes US goods more expensive abroad, hurting exports.
✕ Confusing Supply and Demand Shifts
Foreign investors buying US assets increases demand for USD: not supply. Americans buying foreign assets increases supply of USD.
✕ Ignoring the NX-to-AD Link
A change in \(NX\) doesn't just affect trade: it shifts \(AD\). Always complete the chain to real GDP and price level effects.

Question 1 of 5

If US interest rates increase relative to European interest rates, what will happen to the value of the US dollar and US net exports?

Question 2 of 5

In the foreign exchange market for the Japanese yen, which of the following would cause the yen to depreciate?

Question 3 of 5

Country X's currency depreciates. Which of the following is a likely short-run effect?

Question 4 of 5

If the supply of US dollars in the foreign exchange market increases, which of the following will occur?

Question 5 of 5

The Federal Reserve pursues expansionary monetary policy. Trace the effect through the foreign exchange market. What happens to net exports?