Foreign Exchange Market Notes

Foreign Exchange Market

One of the five key graphs for the AP Macro exam is the Foreign Exchange Market, dealing with exchange rates and currency values.

Graph Setup

• Axes: Quantity of dollars (x-axis) and Exchange Rate (number of euros per dollar, y-axis).
• Curves: Downward sloping demand curve and upward sloping supply curve.

Demand and Supply

• Demand for Dollars: Primarily by Europeans (or individuals from other countries), not Americans.
• Supply of Dollars: Primarily by Americans.

Shifters of the Foreign Exchange Market

Four main shifters:

• Taste and preferences
• Income
• Price level
• Interest rates

Currency Fluctuations

• Increase in demand for dollars: Dollar appreciates.
• Decrease in demand for dollars: Dollar depreciates.

Important Considerations

• Currencies cannot appreciate against each other simultaneously; one appreciates while the other depreciates.
• Appreciation isn't always good; depreciation isn't always bad.
• Example: Dollar depreciation leads to increased net exports because other countries buy more US goods, and the US buys fewer foreign goods, increasing aggregate demand.
• Exporters benefit from a depreciated dollar.

Scenarios

1. Increased European Travel to the US
   • Increases demand for dollars.
   • Dollar appreciates.
2. Recession in Europe (Decreased Incomes)
   • Decreases demand for dollars.
   • Dollar depreciates.
3. Increased Inflation in the United States
   • Decreases demand for dollars (Europeans buy less American goods).
   • Increases supply of dollars (Americans buy more European goods).
   • Double Shift: Demand decreases, and supply increases.
   • Dollar depreciates.
4. Higher Relative Interest Rates in the United States
   • Increases demand for dollars (Europeans buy American bonds).
   • Decreases supply of dollars (Americans buy fewer European assets).
   • Double Shift: Demand increases, and supply decreases.
   • Dollar appreciates.