#AP Macroeconomics: Foreign Exchange Market - The Night Before 🚀

Hey! Let's get this bread 🥖! You've got this. We're going to break down the foreign exchange market (FOREX) so it all clicks, just in time for the exam. Let's dive in!

#Understanding the Foreign Exchange (FOREX) Market

# Demand for Foreign Exchange 🌍

Foreign exchange demand isn't about wanting money itself, but about wanting a currency to buy stuff or invest. Think of it like this: if Europeans want more American goods or want to invest in the U.S., they need to demand more dollars. This shifts the demand curve for dollars to the right, increasing the exchange rate (making the dollar more expensive).

• Key Concept: Demand for a currency is driven by the desire to purchase goods/services or invest in that country.

Caption: Increase in demand for US dollars shifts the demand curve to the right, increasing the exchange rate.

• Inverse Relationship:
  • Exchange rate ⬆️, quantity of currency demanded ⬇️
  • Exchange rate ⬇️, quantity of currency demanded ⬆️

# Supply of Foreign Exchange 💸

Foreign exchange supply is about how much of a currency people are willing to sell at different exchange rates. If Americans want more European goods or want to invest in Europe, they'll supply more dollars to buy euros. This shifts the supply curve for dollars to the right, decreasing the exchange rate (making the dollar less expensive).

• Key Concept: Supply of a currency is driven by the desire to purchase goods/services or invest in other countries.

Caption: Increase in supply of US dollars shifts the supply curve to the right, decreasing the exchange rate.

• Direct Relationship:
  • Exchange rate ⬆️, quantity of currency supplied ⬆️
  • Exchange rate ⬇️, quantity of currency supplied ⬇️

# FOREX Market Equilibrium ⚖️

Equilibrium is where the magic happens! It's where the quantity of a currency demanded equals the quantity supplied. This point determines the exchange rate. Because exchange rates are flexible, they constantly adjust to stay at or near equilibrium.

Caption: The equilibrium exchange rate is where the supply and demand curves intersect.

# Connection to Monetary Policy 🏦

Monetary policy and the FOREX market are like two peas in a pod! Changes in interest rates significantly affect exchange rates.

• Expansionary Monetary Policy (Increase Money Supply):

  • Interest rates ⬇️
  • Demand for the dollar ⬇️ (less attractive for investment)
  • Dollar depreciates
  • Net exports ⬆️ (US goods cheaper for foreigners)
  • AD shifts right
  • Dollar appreciates (eventually)

• Contractionary Monetary Policy (Decrease Money Supply):

  • Interest rates ⬆️
  • Demand for the dollar ⬆️ (more attractive for investment)
  • Dollar appreciates
  • Net exports ⬇️ (US goods more expensive for foreigners)
  • AD shifts left

# Summary: Factors Affecting Exchange Rates 📝

Here's a quick rundown of what makes a currency appreciate (increase in value):

• Increased demand for a country's goods/services
• Increased relative income of foreigners
• Decreasing domestic price levels
• Speculation that the currency will rise
• Higher domestic interest rates

#Final Exam Focus 🎯

• High-Priority Topics:
  • Supply and demand in the FOREX market
  • Impact of monetary policy on exchange rates
  • Factors causing currency appreciation/depreciation
• Common Question Types:
  • Graphing shifts in supply and demand
  • Analyzing the effects of interest rate changes
  • Explaining the impact of exchange rate fluctuations on trade
• Last-Minute Tips:
  • Time Management: Quickly identify the core issue in each question.
  • Common Pitfalls: Avoid confusing capital and financial investments.
  • Strategies: Use graphs to visualize the effects of changes. Always explain the why behind shifts in the curves.

# Practice Questions

Practice Question

#Multiple Choice Questions

1. Which of the following would cause the dollar to depreciate? (A) An increase in U.S. interest rates (B) A decrease in European interest rates (C) An increase in the demand for U.S. exports (D) An increase in the supply of U.S. dollars in the foreign exchange market (E) A decrease in the U.S. price level

2. If the exchange rate between the U.S. dollar and the euro changes from $1 = 0.80 euro to$1 = 0.90 euro, then (A) the dollar has depreciated and U.S. exports will likely increase (B) the dollar has depreciated and U.S. exports will likely decrease (C) the dollar has appreciated and U.S. exports will likely increase (D) the dollar has appreciated and U.S. exports will likely decrease (E) the euro has appreciated and U.S. imports will likely decrease

#Free Response Question

Assume the United States and Japan are trading partners. The current exchange rate is 1 dollar = 100 yen.

(a) Draw a correctly labeled graph of the foreign exchange market for the U.S. dollar, showing the equilibrium exchange rate. Label the vertical axis "Price of U.S. Dollar (in Yen)" and the horizontal axis "Quantity of U.S. Dollars".

(b) Suppose the demand for Japanese goods by U.S. consumers increases. Show the effect of this change on your graph in part (a). Explain how this change affects the exchange rate between the dollar and the yen.

(c) Given the change in the exchange rate, explain how this will impact U.S. exports and imports.

(d) Now, assume the Federal Reserve decides to increase the money supply. Explain how this will impact the U.S. interest rates, and how it will affect the exchange rate between the dollar and the yen.

#FRQ Scoring Guide

(a) Graph (3 points): - One point for correctly labeled axes (price of U.S. dollar in yen on the vertical axis, quantity of U.S. dollars on the horizontal axis). - One point for a downward-sloping demand curve for dollars. - One point for an upward-sloping supply curve for dollars, with the equilibrium point clearly marked.

(b) Demand Shift (2 points): - One point for showing a shift in the demand curve for dollars to the left. - One point for explaining that the increased demand for Japanese goods increases the supply of dollars and depreciates the dollar relative to the yen.

(c) Impact on Trade (2 points): - One point for explaining that U.S. exports will decrease because they are now more expensive for the Japanese to buy. - One point for explaining that U.S. imports will increase because they are now cheaper for Americans to buy.

(d) Monetary Policy Impact (3 points): - One point for explaining that increasing the money supply will decrease U.S. interest rates. - One point for explaining that decreased interest rates will decrease demand for the dollar, causing it to depreciate relative to the yen. - One point for explaining that decreased interest rates will cause capital flight, increasing the supply of dollars and depreciating the dollar.

You're all set! Go crush that exam! 💪