Unit 6 Open Economy Macroeconomics: Exchange Rates, Net Exports, and Capital Flows

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

What the foreign exchange market is (and why AP Macro cares)

The foreign exchange market (FOREX) is the market where currencies are traded—people and firms exchange one country’s money for another country’s money. In AP Macroeconomics, FOREX matters because exchange rates help determine net exports and therefore aggregate demand. Exchange rates also connect to financial flows—when investors move money across borders to buy bonds, stocks, or real assets, those transactions require exchanging currencies.

An exchange rate is the price of one currency in terms of another. On the AP exam, you’ll often see it phrased as “euros per dollar” or “yen per dollar.” You must read the quote carefully because it tells you what “appreciation” means.

  • If the exchange rate is quoted as “foreign currency per dollar,” then a higher number means the dollar buys more foreign currency—so the dollar is stronger.

A dollar appreciation means the dollar becomes more valuable relative to other currencies. A dollar depreciation means the dollar becomes less valuable.

How the FOREX graph works

AP typically models the foreign exchange market for the dollar with:

  • Vertical axis: exchange rate (price of dollars, measured in foreign currency per dollar)
  • Horizontal axis: quantity of dollars exchanged

Then you interpret:

  • Demand for dollars comes from foreigners who want dollars to buy U.S. goods, services, and assets.
  • Supply of dollars comes from Americans who sell dollars to buy foreign goods, services, and assets.

The equilibrium exchange rate is where quantity of dollars demanded equals quantity of dollars supplied.

A helpful way to keep this straight: the model is about the market for dollars, not the market for “foreign currency.” If the demand for dollars rises, the dollar tends to appreciate.

What shifts demand and supply (mechanisms, not memorization)

In AP Macro, you’re usually asked to reason from a policy or economic change to a shift in demand or supply of dollars, then to an exchange rate change.

Below are the big drivers and the logic behind them.

1) Changes in U.S. interest rates (often caused by monetary policy)

Interest rates affect international investors’ decisions.

  • If U.S. interest rates rise relative to foreign rates, U.S. financial assets (like bonds) become more attractive.
  • Foreign investors must buy dollars to buy those U.S. assets.
  • That increases demand for dollars.
  • The dollar appreciates.

This is the classic chain you’ll use for a contractionary monetary policy scenario.

Important nuance (AP level): In open-economy reasoning, it’s the real interest rate that most directly drives international capital flows (you’ll learn this explicitly in the last section). But exam questions commonly phrase it as “interest rates rise,” and the intended reasoning is “capital inflow increases, demand for dollars increases.”

2) Changes in foreign interest rates

This is the mirror image.

  • If foreign interest rates rise relative to U.S. rates, U.S. investors want more foreign assets.
  • U.S. investors must sell dollars to buy foreign currency.
  • That increases the supply of dollars.
  • The dollar depreciates.
3) Changes in income (GDP) at home or abroad

Income affects import demand.

  • If U.S. income rises, Americans buy more of all goods, including imports.

    • More imports means Americans need more foreign currency.
    • Americans sell more dollars in FOREX.
    • Supply of dollars increases.
    • Dollar tends to depreciate.

  • If foreign income rises, foreigners buy more U.S. exports.

    • They need dollars to buy U.S. goods.
    • Demand for dollars increases.
    • Dollar tends to appreciate.

Students often mix up this direction—always anchor it to “who needs dollars to buy what?”

4) Relative price levels (inflation differences)

If U.S. prices rise faster than foreign prices, U.S. goods become relatively more expensive.

  • Foreigners buy fewer U.S. exports (lower demand for dollars).
  • Americans buy more imports (higher supply of dollars).
  • Both forces push toward dollar depreciation.

The opposite is true if foreign inflation is higher than U.S. inflation.

5) Trade policies: tariffs, quotas, and export subsidies

Trade barriers change import and export volumes, which changes currency exchange needs.

  • A tariff (tax on imports) or quota (limit on import quantities) tends to reduce U.S. imports.
    • Americans demand less foreign currency.
    • Americans supply fewer dollars in FOREX.
    • Supply of dollars decreases.
    • Dollar tends to appreciate.

This can feel counterintuitive because “blocking imports” sounds like it should help domestic producers, but in a currency-market framework, fewer imports means fewer dollars being sold.

An export subsidy tends to raise exports.

  • Foreigners need more dollars to buy U.S. exports.
  • Demand for dollars increases.
  • Dollar tends to appreciate.
6) Expectations about future exchange rates

If investors expect the dollar to appreciate in the future, dollar-denominated assets look more attractive.

  • Foreigners want to buy dollars now.
  • Demand for dollars increases.
  • Dollar appreciates today.

AP questions sometimes include a sentence like “investors expect the dollar to strengthen”—that’s your clue.

“Show it in action” examples (step-by-step)

Example 1: Contractionary monetary policy in the U.S.

Suppose the Federal Reserve takes an action that raises U.S. interest rates.

  1. U.S. interest rates rise relative to foreign rates.
  2. Foreign investors increase purchases of U.S. bonds and other assets.
  3. To buy U.S. assets, foreigners must obtain dollars.
  4. Demand for dollars in the FOREX market increases.
  5. The equilibrium exchange rate rises (dollar appreciates).

A very common follow-up (covered in the next section): the stronger dollar reduces net exports.

Example 2: U.S. enters a recession (falling U.S. income)
  1. U.S. income falls.
  2. Americans buy fewer imports.
  3. Americans need less foreign currency, so they sell fewer dollars.
  4. Supply of dollars decreases.
  5. The dollar appreciates.

Notice what drove appreciation here: not “the economy is strong,” but “imports fell, reducing the supply of dollars.” That’s why you must reason from the market mechanism.

What goes wrong: common conceptual traps

  • Mixing up “demand for dollars” with “demand for foreign currency.” On the AP graph, if foreigners want U.S. goods or U.S. assets, they demand dollars.
  • Assuming “good news for the U.S.” always implies appreciation. Some good news raises imports (higher income), which can increase the supply of dollars and push toward depreciation.
  • Forgetting that financial transactions (buying assets) are part of FOREX demand/supply, not just trade in goods.
Exam Focus
  • Typical question patterns:
    • “U.S. interest rates rise. Show the change in the market for dollars and explain what happens to the exchange rate.”
    • “Foreign income increases. What happens to demand/supply for dollars and the value of the dollar?”
    • “A tariff reduces imports. What happens in the foreign exchange market?”
  • Common mistakes:
    • Shifting the wrong curve (for example, saying a tariff increases supply of dollars). Ask: did Americans need to sell more dollars or fewer?
    • Treating appreciation/depreciation as the curve shift rather than the result. Curves shift; exchange rate moves.
    • Ignoring capital flows when the prompt mentions interest rates or investment.

Changes in the Foreign Exchange Market and Net Exports

Net exports: definition and why exchange rates matter

Net exports (NX) is exports minus imports. It captures how much domestic production is demanded by the rest of the world relative to how much foreign production is demanded by domestic buyers.

NX = X - M

  • X = exports
  • M = imports

In the aggregate expenditure model, net exports directly affects GDP:

Y = C + I + G + NX

So when exchange rates change NX, they also change aggregate demand and equilibrium output in the short run.

The core mechanism: appreciation vs depreciation

Exchange rate changes affect trade primarily through relative prices.

If the dollar appreciates

When the dollar becomes more valuable:

  • U.S. imports become cheaper for Americans (foreign goods cost fewer dollars).
  • U.S. exports become more expensive for foreigners (U.S. goods cost more in foreign currency).

So, holding everything else constant:

  • Imports rise
  • Exports fall
  • Net exports fall
If the dollar depreciates

When the dollar becomes less valuable:

  • Imports become more expensive for Americans.
  • Exports become cheaper for foreigners.

So, holding everything else constant:

  • Imports fall
  • Exports rise
  • Net exports rise

A useful memory aid: A-P-P: Appreciation leads to more foreign Purchases (imports) and fewer domestic Purchases by foreigners (exports), so NX goes down.

Connecting the FOREX graph to NX (how exam questions link them)

AP questions often set this up in two steps:

  1. Something shifts demand or supply of dollars, changing the exchange rate.
  2. The exchange rate change affects NX.

For example:

  • Demand for dollars increases ⟶ dollar appreciates ⟶ exports fall and imports rise ⟶ NX decreases.

This connection is so common that you should be able to run it forward and backward:

  • If the question says NX decreased because of exchange rates, a likely story is that the dollar appreciated.

Why the direction is not “because the U.S. is richer”

Students sometimes explain NX changes using income rather than exchange rates, which can be right in other contexts, but here you must use price effects.

  • Appreciation changes the relative prices of imports and exports even if incomes are unchanged.
  • That price change alters quantities demanded of imports and exports, changing NX.

Worked example: a stronger dollar and aggregate demand

Suppose the dollar appreciates due to increased foreign demand for U.S. financial assets.

  1. Dollar appreciates.
  2. U.S. exports become more expensive for foreigners ⟶ exports decrease.
  3. Imports become cheaper for Americans ⟶ imports increase.
  4. NX = X - M falls because X falls and M rises.
  5. In Y = C + I + G + NX, a fall in NX reduces aggregate demand.
  6. In the short run, lower AD tends to reduce real GDP and lower the price level (assuming other factors constant).

Notice how open-economy financial changes can spill into the real economy through NX.

A second example: depreciation after a fall in U.S. interest rates

Suppose U.S. interest rates fall.

  1. U.S. financial assets are less attractive to foreign investors ⟶ foreign demand for dollars falls.
  2. The dollar depreciates.
  3. Depreciation makes exports cheaper to foreigners and imports more expensive to Americans.
  4. Exports rise, imports fall ⟶ NX rises.
  5. Higher NX raises aggregate demand.

What goes wrong: common misconceptions about NX and exchange rates

  • Confusing currency appreciation with “exports increase.” It’s the opposite: appreciation tends to reduce exports.
  • Forgetting imports are subtracted in NX. If imports increase, NX decreases even if exports are unchanged.
  • Assuming NX always moves one-for-one with the exchange rate. In reality there can be lags and other influences, but for AP exam logic, the direction above is the intended mechanism.
Exam Focus
  • Typical question patterns:
    • “The dollar appreciates. What happens to exports, imports, and net exports?”
    • “A shift in the demand for dollars occurs. Explain the impact on net exports and aggregate demand.”
    • “Given a policy change (like higher interest rates), trace the effect through exchange rates to NX.”
  • Common mistakes:
    • Saying “appreciation increases NX” (it typically decreases NX).
    • Mixing up which side of NX = X - M changes: students often say “imports rise so NX rises.” Remember imports enter with a minus sign.
    • Skipping the step about relative prices. On AP, the clean explanation is: exchange rate changes relative prices ⟶ trade quantities ⟶ NX.

Real Interest Rates and International Capital Flows

What “international capital flows” means

International capital flows are movements of financial capital across borders—money flowing into a country to buy assets (capital inflow) or flowing out to buy foreign assets (capital outflow). These flows matter because they:

  • Affect the demand and supply of currencies in FOREX
  • Finance trade deficits or reflect trade surpluses
  • Link domestic saving and investment to the rest of the world

AP Macro often compresses a lot of this into a few key relationships.

Real interest rates: the key price for global investors

The real interest rate is the inflation-adjusted return on saving and borrowing. A common approximation is:

r = i - \pi^e

  • r = real interest rate
  • i = nominal interest rate
  • \pi^e = expected inflation

Why “real” matters: investors care about purchasing power. If a bond pays a high nominal rate but inflation is also high, the real return may be low.

In the AP open-economy model, differences in real interest rates across countries help explain why financial capital moves.

Net capital outflow (NCO) and its relationship to the real interest rate

AP often uses net capital outflow (NCO) to summarize capital flows.

  • NCO is the amount of domestic financial capital that leaves the country to buy foreign assets minus foreign capital that enters to buy domestic assets.

A key AP relationship is:

  • When the domestic real interest rate rises (relative to abroad), domestic assets become more attractive.
  • Foreigners buy more domestic assets (capital inflow rises), and domestic residents buy fewer foreign assets.
  • Net capital outflow falls (it can even become negative, meaning net capital inflow).

So, in the usual AP story:

  • Higher domestic r ⟶ lower NCO
  • Lower domestic r ⟶ higher NCO

This is commonly represented as a downward-sloping relationship between r and NCO.

The accounting identity linking saving, investment, and international flows

In open-economy macro, national saving can fund either domestic investment or foreign investment. The AP identity you use is:

NCO = S - I

  • S = national saving
  • I = domestic investment

Interpretation:

  • If S > I, the country has excess saving and can lend/invest abroad ⟶ NCO is positive.
  • If S < I, the country needs foreign funds to finance investment ⟶ NCO is negative (net capital inflow).

AP also links NCO to net exports:

NCO = NX

This equality is powerful because it connects the financial side (capital flows) to the trade side (exports and imports). Intuitively:

  • If you buy more foreign assets than foreigners buy of your assets (positive NCO), you must be sending funds abroad—and those funds ultimately correspond to selling more goods/services abroad than you buy (a trade surplus, positive NX).
  • If foreigners are financing your purchases (negative NCO), that corresponds to importing more than you export (a trade deficit, negative NX).

How real interest rates, NCO, and the exchange rate fit together

You can tie the whole unit together in one chain:

  1. A change in policy/economic conditions changes S or I and/or changes the equilibrium real interest rate r.
  2. The real interest rate influences NCO (international capital flows).
  3. NCO affects the foreign exchange market because buying foreign assets requires exchanging currency.
  4. The exchange rate changes, which changes NX.

A common AP way to express step 3 is: if Americans increase purchases of foreign assets, they supply more dollars in the FOREX market.

  • Higher NCO ⟶ more dollars supplied in FOREX ⟶ dollar depreciates
  • Lower NCO ⟶ fewer dollars supplied in FOREX ⟶ dollar appreciates

Then from the earlier section:

  • Depreciation ⟶ NX rises
  • Appreciation ⟶ NX falls

Worked example: expansionary fiscal policy and crowding out with an open economy twist

Suppose the government increases spending without raising taxes (a budget deficit increases).

  1. Public saving falls, so national saving S falls.
  2. With lower S, the supply of loanable funds decreases ⟶ equilibrium real interest rate r rises.
  3. Higher r attracts foreign capital (capital inflow increases) and discourages domestic buying of foreign assets.
  4. NCO falls.
  5. With lower NCO, fewer dollars are supplied to the FOREX market (because fewer dollars are being exchanged to buy foreign assets).
  6. The dollar appreciates.
  7. Appreciation reduces NX.

This is one reason fiscal expansion can be partly offset: higher government spending may raise GDP, but a stronger currency can reduce net exports.

Worked example: increase in domestic saving and its international impact

Suppose households decide to save more (or the government reduces its budget deficit), increasing national saving S.

  1. S rises ⟶ supply of loanable funds increases ⟶ equilibrium r falls.
  2. Lower r makes domestic assets less attractive relative to foreign assets.
  3. NCO rises as domestic investors buy more foreign assets.
  4. More foreign asset purchases require selling dollars ⟶ supply of dollars in FOREX increases.
  5. Dollar depreciates.
  6. Depreciation increases NX.

This example highlights a subtle but important idea: higher saving can be associated with a weaker currency and higher net exports, even if nothing about “trade policy” changed.

What goes wrong: typical reasoning errors

  • Confusing “capital inflow” with “NCO increases.” Capital inflow means foreigners are buying domestic assets, which tends to make NCO smaller (possibly negative).
  • Treating NCO and NX as unrelated. On AP, you should be ready to use NCO = NX as a link between financial flows and trade outcomes.
  • Ignoring expected inflation when asked about “real” interest rates. If expected inflation rises while nominal rates stay the same, the real rate falls.
Exam Focus
  • Typical question patterns:
    • “If the real interest rate in the U.S. rises, what happens to net capital outflow and the exchange rate?”
    • “Given S and I changes, determine the direction of NCO and NX using NCO = S - I and NCO = NX.”
    • “Trace the effects of fiscal or monetary policy through r, NCO, the exchange rate, and NX.”
  • Common mistakes:
    • Getting the sign wrong on NCO (calling a capital inflow an increase in NCO).
    • Jumping directly from policy to exchange rates without the capital-flow step when the question is clearly about loanable funds and r.
    • Saying “higher interest rates cause depreciation” (in the standard AP mechanism, higher domestic rates tend to appreciate the currency via higher demand for the currency and reduced NCO).