Policies and the Foreign Exchange Market
Change in Demand or Supply in Currency
Four common AP Macroeconomics determinants of currency demand and supply are: (1) changes in tastes/preferences for a country's goods and services, (2) changes in relative income, (3) changes in relative price levels, and (4) changes in real interest rates. Any of these can shift demand for or supply of a currency, changing 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.
In the foreign exchange market, 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 currency. 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.
Trade barriers such as tariffs or quotas reduce imports. When imports fall, domestic consumers buy fewer foreign goods and therefore supply less of their own currency in the foreign exchange market. A decrease in the supply of a currency causes that currency to appreciate, other things equal.
Let's look at some scenarios that fall into these different determinants and see how they affect the various currencies.
- Scenario # 1: Tourists from all over the world travel to Mexico for Vacation.
- The demand for the peso will increase and the peso will appreciate. Appropriately, demand will shift to the right.
- Scenario # 2: The price of U.S. exports increase. How would this affect the demand for the U.S. dollar?- It would cause the demand for U.S. goods to decrease which would cause the demand for the dollar to decrease. The U.S. Dollar would depreciate. Appropriately, demand will shift left.
- Scenario # 3: An economic boom causes income levels to increase for Chinese consumers causing them to increase their demand for German goods.- The demand for the euro will increase, as Chinese consumers must exchange Chinese yuan for euros to buy German goods. The euro will appreciate as demand shifts to the right.
- Scenario # 4: Japanese real interest rates are higher than interest rates in the United States.- The demand for the Yen will increase and the Yen will appreciate.
Fiscal Policy Impact on Exchange Rates
When the government practices an expansionary fiscal policy (increase in spending or decrease in taxes), there is an effect on the exchange rate for that country's currency. The example below shows what would happen if this occurs in the United States.
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 increase interest rates 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. As a result, the domestic currency appreciates.
When the government practices a contractionary fiscal policy (decreases spending or increases taxes), there is an effect on the exchange rate of that country's currency. The example below shows what would happen if this occurs in the United States.
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 Impact on Exchange Rates
Monetary policy affects exchange rates primarily 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. 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.
If the central bank of a country is practicing an expansionary monetary policy (decreasing the reserve ratio, decreasing the discount rate, or buy bonds) it will have an effect on the exchange rate as well. In the following example, we are looking at the actions of 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 to buy those assets. As demand for the U.S. dollar decreases, the dollar depreciates. Expansionary monetary policy can also increase aggregate demand and the price level, but the key foreign-exchange mechanism emphasized in AP Macroeconomics is the fall in interest rates and the resulting decrease in demand for the currency.
If the central bank of a country is practicing a contractionary monetary policy (increasing the reserve ratio, increasing the discount rate, or selling bonds), it will have an effect on the value of the exchange rate. In the following example, we are looking at the actions of the Federal Reserve in the United States.
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 to buy those assets. As demand for the U.S. dollar increases, the dollar appreciates. Contractionary monetary policy can also reduce aggregate demand and the price level, but the key foreign-exchange mechanism emphasized in AP Macroeconomics is the rise in interest rates and the resulting increase in demand for the currency.
Trade Barriers and the Foreign Exchange Market
For AP Macroeconomics, the key point is that 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. A tariff raises the price of imports for domestic consumers, which reduces the quantity of imports purchased. An import quota sets a maximum amount of goods that can be imported. Like tariffs, quotas reduce the quantity of imports. Both tariffs and quotas 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.
Vocabulary
The following words are mentioned explicitly in the College Board Course and Exam Description for this topic.
| Term | Definition |
|---|---|
| aggregate demand | The total quantity of goods and services demanded across an entire economy at different price levels. |
| demand | The quantity of a good or service that consumers are willing and able to buy at various price levels. |
| demand for currency | The quantity of a currency that buyers are willing and able to purchase at various exchange rates, arising from demand for a country's goods, services, and financial assets. |
| equilibrium exchange rate | The exchange rate at which the quantity of currency demanded equals the quantity supplied, determined by shifts in currency demand and supply. |
| exchange rate | The price of one currency expressed in terms of another currency in the foreign exchange market. |
| fiscal policy | Government spending and taxation decisions that influence aggregate demand, real output, price level, and exchange rates. |
| flexible exchange market | A foreign exchange market where the equilibrium exchange rate is determined freely by the interaction of supply and demand without government intervention. |
| foreign exchange market | The global market where currencies are traded and exchange rates are determined by the supply and demand for different currencies. |
| interest rates | The cost of borrowing money, influenced by monetary policy and affecting exchange rates through changes in currency demand. |
| monetary policy | Central bank actions that influence the money supply, interest rates, aggregate demand, real output, price level, and exchange rates. |
| price level | The average of all prices of goods and services produced in an economy, typically measured by price indices like the CPI. |
| quotas | Limits on the quantity of imported goods that affect the supply of foreign currency. |
| real output | The total production of goods and services in an economy adjusted for inflation, measured in constant dollars. |
| supply | The quantity of a good or service that producers are willing and able to offer for sale at various price levels. |
| supply of currency | The quantity of a currency that sellers are willing and able to offer at various exchange rates, arising from making payments in other currencies. |
| tariffs | Taxes imposed on imported goods that affect the supply of foreign currency. |
Frequently Asked Questions
What is the foreign exchange market and how does currency demand work?
The foreign exchange (FX) market is where people buy and sell one country’s currency for another—exchange rates are set by supply and demand for currencies. Currency demand comes from foreigners who want your country’s goods, services, or financial assets. Key determinants that shift demand: foreign demand for your exports, higher domestic interest rates (attract capital inflows), lower domestic inflation (real goods cheaper), and expectations of appreciation. Supply of your currency rises when residents buy foreign goods, invest abroad, or expect depreciation. Changes shift the FX demand/supply curves and change the equilibrium exchange rate: a rightward shift in demand → appreciation; a rightward shift in supply → depreciation. On the AP exam you’ll often need to draw the FX market and show shifts (Topic 6.4). For a clear review and practice problems, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd) and practice sets (https://library.fiveable.me/practice/ap-macroeconomics).
How do I know when to shift the demand curve vs supply curve for currency on a graph?
Think: what causes people to want more of a currency (demand) vs what causes holders to sell it (supply). Shift the demand curve when a change makes foreigners want more of that country’s goods, services, or financial assets—e.g., higher foreign demand for exports, higher domestic interest rates attracting capital, or increased investor confidence. Shift the supply curve when domestic residents want to buy more foreign goods/assets—e.g., higher domestic income raising imports, tariffs/quota changes that reduce foreign purchases (which lower supply), or expecting depreciation so residents sell currency now. On a graph: anything that changes foreigners’ desire to hold your currency moves demand (right = appreciation, left = depreciation). Anything that changes your residents’ desire to exchange currency moves supply (right = depreciation, left = appreciation). For AP free-response, draw a correctly labeled foreign-exchange graph and show the curve that shifts and the new equilibrium rate (CED MKT-5.E.1–E.3). For a quick refresher, check the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
I'm confused about how tariffs affect currency supply - can someone explain this?
Tariffs make imports more expensive, so consumers and firms buy fewer foreign goods. To buy fewer imports, the country’s residents sell less of their own currency to get foreign currency—that reduces the supply of the domestic currency in the foreign-exchange market (supply curve shifts left). With lower supply and unchanged demand, the domestic currency appreciates (exchange rate rises). On the AP CED this is EK MKT-5.E.1: tariffs/quotas shift currency supply. In a free-response you’d show this with a foreign-exchange graph (label supply, demand, and the appreciation). For more review, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd) and Unit 6 overview (https://library.fiveable.me/ap-macroeconomics/unit-6). For extra practice, try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
What's the difference between factors that shift currency demand and currency supply?
Think of the foreign exchange market like any market: demand is from people who want to buy a country’s goods, services, or assets (they need that country’s currency); supply is from people in that country who want foreign goods, services, or assets (they sell their currency). So factors that shift currency demand increase or decrease foreigners’ desire to hold that currency—e.g., higher foreign demand for the country’s exports, higher domestic interest rates attracting foreign investors, or positive expectations/speculation about that currency. Factors that shift currency supply change how much of the currency residents sell—e.g., tariffs/quotas on imports (reduce supply), higher domestic demand for imports, domestic investors buying foreign assets, or capital controls. On the AP exam you should show these shifts on a supply-demand graph of the FX market and explain how they change the equilibrium exchange rate (CED Topic 6.4). For a concise recap and examples, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd). Want practice problems? Try the AP macro practice bank (https://library.fiveable.me/practice/ap-macroeconomics).
How does fiscal policy affect exchange rates and which way do the curves shift?
Expansionary fiscal policy (higher G or lower T) raises domestic aggregate demand, output, and often domestic interest rates (crowding-out). Higher interest rates attract foreign capital, increasing demand for the domestic currency—so the demand curve for that currency shifts right in the foreign-exchange market, causing appreciation (exchange rate rises). Contractionary fiscal policy does the opposite: AD falls, interest rates/ capital attraction fall, demand for the domestic currency shifts left, and the currency depreciates. On FRQs you should draw the FX market with the demand curve for domestic currency shifting right (expansionary) or left (contractionary) and label the new equilibrium exchange rate. This matches EK MKT-5.E.2 (fiscal policy → AD, output, price level, exchange rates). For a concise walkthrough, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd) and additional unit review (https://library.fiveable.me/ap-macroeconomics/unit-6). For practice drawing these graphs, try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
When the Fed raises interest rates, does that increase or decrease demand for dollars?
Increase—when the Fed raises U.S. interest rates, U.S. financial assets become more attractive to foreign investors. That raises net financial capital inflows and increases the demand for dollars (investors need dollars to buy U.S. bonds, stocks, etc.). On a foreign exchange graph, the demand curve for dollars shifts right, the dollar appreciates (exchange rate rises), and U.S. exports become relatively more expensive (exports tend to fall). This ties directly to CED EK MKT-5.E.1 and EK MKT-5.E.3 about interest-rate differentials and capital flows. For AP FRQs you’d show a rightward shift in D$ and label the higher exchange rate (Topic 6.4 requires you to explain shifts and equilibrium effects). Review this topic here (study guide: https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd) and try practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
I don't understand how buying foreign goods affects the supply of domestic currency - help?
When you buy foreign goods, you need the seller’s currency to pay them. So you sell your domestic currency in the foreign exchange market and buy the foreign currency—that increases the supply of your domestic currency. In supply/demand terms: higher demand for imports → more people supplying domestic currency → supply curve for domestic currency shifts right. That extra supply tends to lower the domestic currency’s value (depreciation), making imports more expensive and exports cheaper until net exports and exchange rate reach a new equilibrium (EK MKT-5.E.1). On the AP exam you should be able to show this on a foreign-exchange graph: label axes, shift the supply curve right, and show depreciation. For extra practice and examples, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd), the Unit 6 overview (https://library.fiveable.me/ap-macroeconomics/unit-6), and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What happens to the equilibrium exchange rate when both currency demand and supply increase?
If both demand for and supply of a currency shift right, the effect on the equilibrium exchange rate is indeterminate without knowing magnitudes. Graphically (FX market with exchange rate on the vertical axis), both a rightward shift of demand and a rightward shift of supply raise the quantity of currency traded. The exchange rate will: - Appreciate if the demand shift > supply shift (demand up more than supply). - Depreciate if the supply shift > demand shift. - Stay the same if the two shifts are equal (exchange rate unchanged, quantity rises). Always show this on a foreign-exchange graph for AP free-response (Skill 4: draw and label shifts). For more examples and practice, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd) and try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
How do I draw the graph showing the effect of expansionary monetary policy on exchange rates?
Draw a standard foreign-exchange graph: vertical axis = exchange rate (price of domestic currency) and horizontal axis = quantity of domestic currency. Label the downward-sloping demand for domestic currency (foreign buyers wanting domestic goods/assets) and the upward-sloping supply of domestic currency (domestic residents converting to foreign currency). Show expansionary monetary policy (central bank increases money supply / lowers domestic interest rates). Because domestic interest rates fall, domestic assets are less attractive → net capital outflow rises. That means more domestic currency is supplied to buy foreign currency (supply shifts right) and/or foreign demand for the domestic currency falls (demand shifts left). On the graph shift supply right (S → S2) or demand left (D → D2). The new equilibrium has a lower exchange rate (domestic currency depreciates). Label the original and new equilibria and write “depreciation of domestic currency” next to the movement. For the AP exam, be sure your graph is correctly labeled (axes, curves, equilibrium points) and identify the direction of shift and whether the currency appreciates or depreciates (Skill 4.A–4.C). Review Topic 6.4 on Fiveable (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd) and do more practice problems at (https://library.fiveable.me/practice/ap-macroeconomics).
Can someone explain why higher GDP in a country increases demand for its currency?
Higher GDP signals a stronger, growing economy, and that raises demand for the country’s currency for two main AP-relevant reasons (EK MKT-5.E.1): 1) More attractive financial assets: Growth often means higher expected returns and/or higher interest rates → foreign investors buy domestic bonds, stocks, and real assets. To buy them they must convert foreign currency into the domestic currency, shifting demand for that currency right (capital inflows). 2) More foreign buyers of goods/services: If higher GDP comes with competitive exports or higher global demand for the country’s output, foreigners need the domestic currency to pay for those goods, also increasing currency demand. On the AP exam, you’d show this with a rightward shift of the currency demand curve and an appreciation of the exchange rate (Topic 6.4). For more review and practice, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd), the Unit 6 overview (https://library.fiveable.me/ap-macroeconomics/unit-6), and extra practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What's the connection between a country's price level and its exchange rate?
Higher domestic price level (higher inflation) makes your country’s goods and services relatively more expensive to foreigners, so demand for your exports falls and foreign demand for your currency falls—that puts downward pressure on your currency (depreciation). This idea is captured by purchasing power parity and “inflation differentials” on the AP CED (EK MKT-5.E.1). Short run caveat: if inflation leads the central bank to raise nominal interest rates, higher rates can attract capital inflows and temporarily appreciate the currency; but persistent higher inflation usually causes depreciation and worsens net exports. On AP free-response you should show this with a foreign-exchange supply/demand graph (shift in demand or supply) and explain effects on the exchange rate and net exports (per Topic 6.4). For a quick refresher, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
How do quotas on imports affect the foreign exchange market differently than tariffs?
Both tariffs and quotas reduce imports, so they both lower your country’s need to buy foreign currency to pay foreign sellers—that reduces the supply of domestic currency (or the demand for foreign currency) in the foreign-exchange market and tends to appreciate the domestic currency. The key difference: a tariff is a price (per-unit tax) that raises the cost of imports and sends revenue to the government; a quota is a quantity limit that creates scarcity and “rents” for whoever gets import rights (foreign exporters or domestic licensees). Economically that means: - Tariff: import volume falls and the gov’t collects revenue. The exchange-rate effect is more predictable and you can show it as a leftward shift in the supply of domestic currency (or left shift in demand for foreign currency) on an FX graph from the CED (Topic 6.4). - Quota: import volume is capped, which can cause larger or more volatile price/FX adjustments and transfers income to quota holders rather than the government. For AP exam practice, draw the FX market and show the supply/demand shift (Topic 6.4 study guide: https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd). For more practice problems, see https://library.fiveable.me/practice/ap-macroeconomics.
I'm studying for the FRQ - how do I explain the complete chain from monetary policy to exchange rates?
Start with the policy: an expansionary monetary policy (Fed lowers interest rates) or contractionary policy (Fed raises rates). Step-by-step chain (use a graph on the FRQ): 1) Monetary policy → domestic nominal interest rates change (lower with expansionary, higher with contractionary). 2) Interest-rate change → affects capital flows: higher domestic rates attract foreign capital (net capital inflows); lower rates cause outflows. 3) Capital flows → shift demand/supply in the foreign exchange market: inflows raise demand for the domestic currency (demand curve shifts right); outflows increase supply of the domestic currency (supply curve shifts right). Draw and label the FX graph (price = exchange rate). 4) Exchange rate moves → currency appreciation with inflows (exchange rate rises), depreciation with outflows. 5) Real effects → appreciation makes exports relatively more expensive (NX falls); depreciation makes exports cheaper (NX rises). Also mention links to AD, output, and price level per the CED (EK MKT-5.E.3). On the FRQ, draw the AD/AS or FX graph, label shifts, and explain each link (interest rates → capital flows → FX demand/supply → exchange rate → net exports). For review, see the Topic 6.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd), Unit 6 overview (https://library.fiveable.me/ap-macroeconomics/unit-6), and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
Why does increased demand for a country's assets shift the currency demand curve right?
Because foreigners need that country’s currency to buy its assets (bonds, stocks, real estate), an increase in demand for those assets raises the quantity of currency they want to buy at every exchange rate. On a foreign-exchange graph that’s a rightward shift of the currency demand curve (EK MKT-5.E.1). Mechanism: higher expected returns or higher interest rates relative to abroad attract capital inflows → foreigners exchange their currency for yours → greater demand for your currency → currency appreciation (higher exchange rate). This is exactly how interest-rate differentials and capital flows link monetary/fiscal policy to exchange rates (EK MKT-5.E.2, MKT-5.E.3). For AP exam answers, draw the FX market, shift demand right, and show appreciation; see the Topic 6.4 study guide for a sample graph and explanation (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd). For more practice, try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
What are all the factors that can shift currency supply and demand curves for the AP exam?
Short answer: demand for a currency rises when foreigners want more of that country’s goods, services, or assets; supply rises when residents want more foreign goods, services, or assets. More specifically, factors that shift demand for a currency (right = more demand/appreciation) include: - Higher foreign demand for the country’s exports (goods/services) - Higher domestic interest rates relative to foreign rates (capital inflows) - Lower domestic inflation vs. trading partners (PPP effect) - Expectations of a future appreciation (speculation) - Removal of capital controls or increased foreign confidence Factors that shift supply of a currency (right = more supply/depreciation) include: - Higher domestic demand for imports - Lower domestic interest rates relative to foreign rates (capital outflows) - Higher domestic inflation vs. trading partners - Expectations of future depreciation - Imposition of tariffs/quotas on foreign partners (can indirectly reduce supply) On the AP exam you should be ready to draw the FX supply/demand graph and show how these shifts change the equilibrium exchange rate (Topic 6.4). Review the topic study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/policies-economic-conditions-foreign-exchange-market/study-guide/sfILXjvT4oI0aHiQCKwd), the Unit 6 overview (https://library.fiveable.me/ap-macroeconomics/unit-6), and practice questions (https://library.fiveable.me/practice/ap-macroeconomics) for examples and graphing practice.