Macroeconomics guide, Unit 6, step 20 of 23Previous step Next step

Step 20: The Foreign Exchange Market

By the EconTutorials team. 10-minute read with 6 practice questions.

SyllabusAP Macro 6.3–6.6 · Cambridge 6.4, 11.2 · IB 4.5

In 30 seconds

An exchange rate is a price: the price of one currency in terms of another. Under a floating system it is set by demand and supply.
Relative interest rates, relative inflation, incomes, tastes and speculation shift the demand and supply curves for a currency.
A higher real interest rate attracts capital inflows, raising demand for the currency, so it appreciates; net exports then fall and AD shifts left.
The AP exam loves the two-graph chain: money market (or loanable funds) → interest rate → foreign exchange market → net exports → AD.

Video lesson coming soonA short animated lesson for this step will appear here.

What an exchange rate is

Suppose you are flying from Dubai to London for a summer course. Before you go, you swap dirhams for pounds. The number of dirhams you hand over for each pound is the exchange rate. It is simply a price, like the price of a coffee, except the thing being bought is another country’s money.

Currencies are traded in the foreign exchange (forex) market. People need foreign currency to buy foreign goods, services and assets. A US shop importing Japanese cameras must pay in yen, so it buys yen with dollars. A Japanese investor buying US government bonds must pay in dollars, so they buy dollars with yen.

Key termExchange rate: the price of one currency expressed in units of another currency, for example £1 = $1.25.

The forex graph: demand and supply of a currency

Take the market for US dollars, priced in euros.

Demand for dollars comes from foreigners who need dollars: Europeans buying US exports, European tourists visiting the US, and Europeans investing in US assets (bonds, shares, factories).
Supply of dollars comes from Americans who want euros: Americans buying European imports, US tourists going to Europe, and Americans investing in European assets. To get euros, they must offer dollars.

The demand curve slopes down: when the dollar is cheap (fewer euros per dollar), US goods are cheaper for Europeans, so they want more dollars. The supply curve slopes up: when the dollar is expensive, European goods look cheap to Americans, so they supply more dollars to buy them.

DiagramTitle the graph “Market for US dollars”. Label the vertical axis “Price of dollar (euros per dollar)” and the horizontal axis “Quantity of dollars”. Draw a downward-sloping D$_\$$ and an upward-sloping S$_\$$. Where they cross, mark the equilibrium exchange rate $ e_1 $ and quantity $ Q_1 $. If demand for dollars increases, shift D$_\$$ right to D$_2$; the new equilibrium is at a higher exchange rate $ e_2 $ and a larger quantity $ Q_2 $. The dollar has appreciated. Always put the same currency on both axes: the price of the dollar on the vertical axis and the quantity of dollars on the horizontal axis.

Key termAppreciation: a rise in the value of a currency in a floating market, so it buys more foreign currency. Depreciation is a fall in its value.

When one currency appreciates, the other must depreciate. If the dollar buys more euros, then each euro buys fewer dollars.

Worked example

For example, the exchange rate moves from £1 = $1.25 to £1 = $1.40. By how much has the pound appreciated? What happens to the dollar price of a £20 British book, and to the value of the dollar?

Step 1$ \text{Change in pound} = \dfrac{1.40 – 1.25}{1.25} \times 100 = 12\% \text{ appreciation} $

Step 2$ \text{Book price in dollars: } 20 \times 1.25 = \$25 \;\rightarrow\; 20 \times 1.40 = \$28 $

Step 3$ \text{Price of } \$1 \text{ in pounds: } \dfrac{1}{1.25} = \text{£}0.80 \;\rightarrow\; \dfrac{1}{1.40} \approx \text{£}0.7143 $

Step 4$ \text{Change in dollar} = \dfrac{0.7143 – 0.80}{0.80} \times 100 \approx -10.7\% $

The pound has appreciated by 12% against the dollar, so British goods are dearer for Americans: the book now costs $28, not $25. The dollar has depreciated by about 10.7% against the pound. The two percentages are not equal because each is measured from a different starting value.

What shifts the curves

Learn the logic, not a list: ask “who now wants more (or less) of this currency, and why?” Here is the market for dollars again, from the point of view of the US.

Change	Effect on the market for dollars	Dollar
US real interest rates rise relative to other countries	Foreigners want US financial assets: demand for dollars rises (and Americans keep more money at home, so supply may fall)	Appreciates
US inflation rises relative to other countries	US goods become relatively dearer: foreigners demand fewer dollars, Americans buy more imports and supply more dollars	Depreciates
US incomes rise	Americans buy more imports, so they supply more dollars	Depreciates
Foreign incomes rise	Foreigners buy more US exports, so demand for dollars rises	Appreciates
Foreign tastes shift towards US goods	Demand for dollars rises	Appreciates
Speculators expect the dollar to rise	They buy dollars now to sell later at a profit: demand rises	Appreciates

Notice the income result surprises many students: faster growth at home tends to depreciate your currency through the trade channel, because you import more.

Common mistakeMixing up the currencies on the graph. If the question is about the market for euros, the vertical axis is “dollars per euro” and the quantity is “euros”. A US interest-rate rise then increases the supply of euros (Europeans sell euros to buy dollars) and the euro depreciates. Always ask whose currency the graph is for before shifting anything.

Effects on net exports and AD

An appreciation makes your exports dearer for foreigners and imports cheaper for you. Exports fall and imports rise, so net exports $ (X – M) $ fall. Because net exports are a component of aggregate demand,

\[ AD = C + I + G + (X – M) \]

an appreciation shifts AD to the left, reducing real GDP and the price level in the short run. A depreciation does the opposite: exports become cheaper abroad, imports dearer at home, net exports rise and AD shifts right. A depreciation can also push up inflation, because imported goods and raw materials cost more.

Real interest rates and international capital flows

Money moves around the world looking for the best return. Investors compare real interest rates (nominal rate minus expected inflation) across countries. If the US real interest rate rises relative to the rest of the world:

US bonds and bank deposits become more attractive.
Financial capital flows into the US (a capital inflow).
To buy US assets, foreigners must buy dollars, so demand for dollars rises.
The dollar appreciates.
US net exports fall, so AD shifts left.

A fall in the relative real interest rate reverses every step: capital flows out, the currency depreciates and net exports rise.

The two-graph AP chain

AP Macroeconomics often asks you to link two graphs. There are two common versions.

Version 1: monetary policy. Suppose the economy is in a recession and the central bank buys government bonds (an open-market purchase).

Money market graph: the money supply curve (vertical) shifts right, and the nominal interest rate falls.
With lower interest rates at home, US assets are less attractive. Capital flows out.
Forex graph for dollars: demand for dollars shifts left (and/or supply of dollars shifts right). The dollar depreciates.
US exports are cheaper abroad, imports dearer: net exports rise, reinforcing the rise in AD from cheaper borrowing.

Version 2: fiscal policy and loanable funds. Suppose the government runs a larger budget deficit and borrows more. In the loanable funds market, demand for loanable funds shifts right and the real interest rate rises. This attracts capital inflows, the dollar appreciates and net exports fall. Economists call this the crowding out of net exports: some of the boost from government spending is cancelled by weaker net exports.

Exam tipAP Macro FRQ: label every axis precisely (for the forex graph: “Price of dollar in euros” and “Quantity of dollars”), show the shift with an arrow, mark old and new equilibria, and write the full chain in words: interest rate → capital flow → demand/supply of the currency → appreciation/depreciation → net exports → AD. AP accepts either a demand shift or a supply shift for interest-rate changes if your direction is right. Cambridge 9708 and IB: explain who buys and sells the currency, use the correct regime word (appreciation/depreciation for floating; revaluation/devaluation for fixed), and evaluate the effect on the current account, inflation and growth.

Fixed versus floating exchange rates

Under a floating exchange rate, the rate is set by market demand and supply, as above. Under a fixed (pegged) rate, the government or central bank sets the rate against another currency and defends it. For example, the Saudi riyal has long been pegged to the US dollar at 3.75 riyals per dollar.

To defend a peg, the central bank buys or sells its own currency using its foreign currency reserves. If market pressure pushes the currency below the peg, the central bank buys its own currency (raising demand) or raises interest rates. A deliberate cut in a fixed rate is a devaluation; a deliberate rise is a revaluation. Many countries sit in between with a managed float, letting the rate move but stepping in to smooth sharp swings.

	Floating	Fixed
Main benefit	Adjusts automatically; monetary policy is free to target the domestic economy	Certainty for traders and investors; can anchor inflation
Main cost	Volatility makes trade and investment riskier	Needs large reserves; interest rates must defend the peg, not the domestic economy

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. The exchange rate changes from €1 = $1.10 to €1 = $1.21. Has the euro appreciated or depreciated, and by what percentage? Show worked answer

Each euro now buys more dollars, so the euro has appreciated.
Change = (1.21 − 1.10) ÷ 1.10 × 100 = 0.11 ÷ 1.10 × 100 = 10%.
(The dollar has depreciated: $1 was worth €0.909 and is now worth €0.826, a fall of about 9.1%.)

EasyQ2. In the market for Japanese yen, which curve shifts, and in which direction, when American consumers buy more Japanese cars? Show worked answer

Americans need yen to pay for the cars, so the demand for yen shifts right. The yen appreciates against the dollar.

MediumQ3. A jacket costs £50 in London. For example, the rate falls from £1 = $1.30 to £1 = $1.20. What happens to its price for an American buyer, and what does this suggest about UK exports? Show worked answer

Before: 50 × 1.30 = $65.
After: 50 × 1.20 = $60.
The pound has depreciated, so British goods are $5 cheaper for Americans. UK exports should rise, increasing UK net exports and AD.

MediumQ4. Mexico’s real interest rate rises while US rates are unchanged. Explain the effect on the value of the Mexican peso and on Mexico’s net exports. Show worked answer

Mexican assets now offer a higher real return, so financial capital flows into Mexico.
Foreign investors must buy pesos, so demand for pesos shifts right.
The peso appreciates.
Mexican exports become dearer abroad and imports cheaper, so Mexico’s net exports fall.

MediumQ5. US inflation rises to 6% while inflation in the eurozone stays at 2%. Using the market for dollars, explain what happens to the dollar. Show worked answer

US goods become relatively more expensive than European goods.
Europeans buy fewer US exports, so demand for dollars shifts left.
Americans switch to cheaper European imports, so the supply of dollars shifts right.
Both shifts lower the price of the dollar: the dollar depreciates against the euro.

ExamQ6. Assume the United States is in a recession with a floating exchange rate. The Federal Reserve buys government bonds on the open market. (a) Draw a correctly labelled money market graph and show the effect on the nominal interest rate. (b) Draw a correctly labelled graph of the foreign exchange market for US dollars and show the effect of your answer in (a). (c) Explain the effect on US net exports and on aggregate demand. [6 marks] Show worked answer

(a) [2 marks] Axes: nominal interest rate (vertical), quantity of money (horizontal), with downward-sloping money demand and vertical money supply [1]. Money supply shifts right; the nominal interest rate falls from $ i_1 $ to $ i_2 $ [1].
(b) [2 marks] Axes: price of dollar in foreign currency (vertical), quantity of dollars (horizontal), with D and S curves [1]. Lower US interest rates make US assets less attractive, so demand for dollars shifts left (or supply shifts right) and the dollar depreciates [1].
(c) [2 marks] A weaker dollar makes US exports cheaper and imports dearer, so net exports increase [1]. Because net exports are a component of AD, AD shifts right, increasing real GDP and helping to close the recessionary gap [1].

Check yourself

1. In the market for dollars, who supplies dollars?

Americans offer dollars in exchange for the foreign currency they need.

2. The UK’s real interest rate rises relative to other countries. What happens to the pound?

Higher real returns attract capital inflows, raising demand for pounds.

3. A country’s currency appreciates. What happens to its net exports and AD?

Exports become dearer and imports cheaper, so (X − M) falls and AD shifts left.

Your score: 0 out of 3

The short version

An exchange rate is the price of one currency in another; on the graph, the price of the currency goes on the vertical axis and its quantity on the horizontal axis.
Demand for a currency comes from foreigners buying its exports and assets; supply comes from residents buying foreign goods and assets.
Higher relative real interest rates, higher foreign incomes, favourable tastes and speculation appreciate a currency; higher relative inflation and higher domestic incomes depreciate it.
Appreciation lowers net exports and shifts AD left; depreciation raises net exports and shifts AD right.
Under a fixed rate the central bank defends the peg with reserves and interest rates; changes are called revaluation or devaluation.