6.4 Effect of Changes in Policies & Economic Conditions on the Foreign Exchange Market

The value of a currency changes when something shifts the demand for or supply of that currency in the foreign exchange market. Anything that makes a country's goods, services, or assets more attractive raises demand for its currency and causes it to appreciate, while higher interest rates, stronger income abroad, and trade barriers all feed into these shifts.

Policies and Exchange Rates Summary

Policies and economic conditions affect exchange rates by shifting currency demand or currency supply. If foreign buyers want more of a country's goods, services, or financial assets, demand for that currency increases and it appreciates. If domestic buyers want more foreign goods, services, or assets, supply of the domestic currency increases and it depreciates.

For AP Macroeconomics, the most tested chain runs through interest rates. Expansionary monetary policy lowers domestic interest rates and tends to depreciate the currency, while contractionary monetary policy raises interest rates and tends to appreciate it. Fiscal policy can also affect exchange rates by changing aggregate demand, output, prices, and interest rates.

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Why This Matters for the AP Macroeconomics Exam

This topic connects almost everything you learned about policy to the global economy. You take fiscal and monetary policy from earlier units and trace how they move interest rates, which then change currency demand and the equilibrium exchange rate. On the AP Macroeconomics exam, you may need to draw a correctly labeled foreign exchange market graph, shift the right curve in the right direction, and explain the cause and effect in words. Free-response questions often chain steps together, so being able to move from a policy action to an interest rate change to a currency value change is exactly the kind of reasoning that earns points.

Key Takeaways

• Demand for a currency comes from foreigners wanting that country's goods, services, or financial assets; supply comes from domestic buyers exchanging their currency to buy foreign goods, services, or assets.
• A rightward shift in demand or leftward shift in supply causes appreciation; a leftward shift in demand or rightward shift in supply causes depreciation.
• Higher relative real interest rates attract foreign financial capital, raising demand for the currency and causing it to appreciate.
• Fiscal policy affects exchange rates through aggregate demand, output, the price level, and interest rates.
• Monetary policy affects exchange rates mainly through interest rates: easing lowers rates and depreciates the currency, tightening raises rates and appreciates it.
• Tariffs and quotas reduce imports, which decreases the supply of the domestic currency and causes it to appreciate.

Determinants of Currency Demand and Supply

Four common determinants of currency demand and supply in AP Macroeconomics are:

1. Changes in tastes or preferences for a country's goods and services
2. Changes in relative income
3. Changes in relative price levels
4. Changes in real interest rates

Any of these can shift the demand for or supply of a currency and change the equilibrium exchange rate. A rightward shift of demand or a leftward shift of supply causes appreciation. A leftward shift of demand or a rightward shift of supply causes depreciation.

Demand for a currency comes from foreigners who want that country's goods, services, or financial assets. Supply of a currency comes from domestic consumers and investors who want foreign goods, services, or financial assets and therefore exchange their own currency into another. For example, if U.S. consumers buy more Japanese goods, the supply of U.S. dollars in the foreign exchange market increases because Americans supply dollars to obtain yen. If a tariff reduces U.S. purchases of foreign goods, the supply of U.S. dollars decreases.

Scenario Practice

Work through these scenarios to see how each determinant moves a currency.

• Scenario 1: Tourists from all over the world travel to Mexico for vacation.

  • Demand for the peso increases and the peso appreciates. Demand shifts to the right.

• Scenario 2: The price of U.S. exports increases. How does this affect demand for the U.S. dollar?

  • Higher prices reduce demand for U.S. goods, which reduces demand for the dollar. The dollar depreciates as demand shifts left.

• Scenario 3: An economic boom raises income for Chinese consumers, who then buy more German goods.

  • Demand for the euro increases as Chinese consumers exchange yuan for euros to buy German goods. The euro appreciates as demand shifts right.

• Scenario 4: Japanese real interest rates are higher than interest rates in the United States.

  • Demand for the yen increases and the yen appreciates.

Fiscal Policy and Exchange Rates

Fiscal policy can influence aggregate demand, real output, the price level, and exchange rates.

Expansionary fiscal policy (higher government spending and/or lower taxes) increases aggregate demand, real output, and the price level in the short run. It also tends to push interest rates up as the government borrows more. Higher domestic interest rates attract foreign financial capital, so foreigners demand more of the domestic currency to buy domestic financial assets. The domestic currency appreciates.

Contractionary fiscal policy (lower government spending and/or higher taxes) decreases aggregate demand, real output, and the price level in the short run. It also tends to lower interest rates, making domestic financial assets less attractive to foreign investors. Foreign demand for the domestic currency decreases, so the domestic currency depreciates.

Monetary Policy and Exchange Rates

Monetary policy can influence aggregate demand, real output, the price level, and interest rates, and through those channels it affects exchange rates. The main path tested in AP Macroeconomics runs through interest rates.

Expansionary monetary policy increases the money supply and lowers interest rates. Lower domestic interest rates make domestic financial assets less attractive to foreign investors, so demand for the domestic currency falls and the currency depreciates. The tools include decreasing the reserve ratio, decreasing the discount rate, or buying bonds. The example below uses the Federal Reserve in the United States.

When the Fed increases the money supply, interest rates fall. Lower U.S. interest rates make U.S. financial assets less attractive relative to foreign assets, so foreigners demand fewer U.S. dollars. As demand for the dollar decreases, the dollar depreciates. Expansionary monetary policy can also raise aggregate demand and the price level, but the foreign exchange mechanism to emphasize is the fall in interest rates and the resulting drop in demand for the currency.

Contractionary monetary policy decreases the money supply and raises interest rates. Higher domestic interest rates attract foreign financial capital, increasing demand for the domestic currency and causing it to appreciate. The tools include increasing the reserve ratio, increasing the discount rate, or selling bonds.

When the Fed decreases the money supply, interest rates rise. Higher U.S. interest rates make U.S. financial assets more attractive relative to foreign assets, so foreigners demand more U.S. dollars. As demand for the dollar increases, the dollar appreciates. The foreign exchange mechanism to emphasize is the rise in interest rates and the resulting increase in demand for the currency.

Trade Barriers and the Foreign Exchange Market

Trade barriers such as tariffs and quotas reduce imports. When imports fall, domestic consumers supply less of their currency in the foreign exchange market, which decreases the supply of the currency and causes it to appreciate, all else equal.

A tariff is a tax on imported goods. It raises the price of imports for domestic consumers, which reduces the quantity of imports purchased. An import quota sets a maximum amount of a good that can be imported. Like tariffs, quotas reduce the quantity of imports. Both have the same effect on the foreign exchange market: by reducing imports, they decrease the supply of the domestic currency and cause it to appreciate.

How to Use This on the AP Macroeconomics Exam

Free Response

Build your answer as a chain. Start with the policy or event, move to the interest rate or aggregate demand effect, then state the shift in currency demand or supply, and finish with appreciation or depreciation. Naming the direction of the shift and the direction of the currency value change is what earns points.

Problem Solving

When you draw the foreign exchange market, label the vertical axis as the exchange rate in terms of one unit of the domestic currency and the horizontal axis as the quantity of that currency. Decide whether the event hits demand or supply, then shift only that curve. Move the equilibrium and read off the new exchange rate.

Common Trap

Watch which currency the question is asking about. An event that appreciates one currency depreciates the other. Keep your graph focused on a single currency so you do not flip the direction by accident.

Common Misconceptions

• Appreciation and depreciation are relative. When one currency appreciates against another, the second currency depreciates against the first. Always track which currency you are graphing.
• Expansionary monetary policy does not appreciate a currency. By lowering interest rates, it makes domestic assets less attractive, reduces demand for the currency, and causes depreciation.
• Tariffs and quotas affect the supply of the domestic currency, not its demand. By reducing imports, they reduce the amount of domestic currency supplied, which causes appreciation.
• Higher domestic prices do not strengthen a currency. They make exports less attractive, which lowers demand for the currency and leads to depreciation.
• A current account change is not the only driver of exchange rates. Financial flows responding to interest rate differences can move a currency just as strongly as trade flows.

Related AP Macroeconomics Guides

• 6.1 Balance of Payments Accounts
• 6.3 Foreign Exchange Market
• 6.2 Exchange Rates
• 6.5 Changes in the Foreign Exchange Market and Net Exports
• Unit 6 Overview: Open Economy-International Trade and Finance
• 6.6 Real Interest Rates and International Capital Flows