#AP Macroeconomics: Foreign Exchange, Fiscal & Monetary Policy, and Trade 🚀

Hey! Let's get you prepped for the AP Macro exam. This guide is designed to be your go-to resource, especially the night before the test. We'll break down key concepts, connect the dots, and make sure you're feeling confident. Let's dive in!

#🌐 Foreign Exchange (FOREX) Market

#🔄 Currency Demand and Supply

Changes in the FOREX market are driven by shifts in the demand and supply of currencies. Here are the four main determinants:

1. Changes in Taste/Preferences: If a country's goods or services become more popular, demand for its currency increases. Think of it like this: if everyone suddenly wants to visit Japan, they'll need Yen! 🇯🇵
2. Changes in Relative Incomes: If a country's income rises, its citizens will import more, increasing the supply of its currency on the market.
3. Changes in Relative Price Levels: If a country's prices rise, its exports become less attractive, reducing demand for its currency.
4. Changes in Relative Interest Rates: Higher interest rates attract foreign investment, increasing demand for a country's currency. 💰

Let's walk through some scenarios:

• Scenario #1: Tourists flock to Mexico 🇲🇽

  • Demand for the Peso increases (rightward shift) and the Peso appreciates.
  • 

• Scenario #2: US export prices rise 📈

  • Demand for US goods decreases, leading to decreased demand for the US dollar (leftward shift). The dollar depreciates.
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• Scenario #3: Chinese consumers buy more German goods 🇩🇪

  • Demand for the Euro increases (rightward shift) as Chinese consumers convert their currency. The Euro appreciates.
  • 

• Scenario #4: Japan's interest rates are higher than in the US 🇯🇵

  • Demand for the Yen increases (rightward shift) as investors seek higher returns. The Yen appreciates.
  • 

Practice Question

Multiple Choice:

1. If the demand for a country's exports increases, what will likely happen to its currency? (A) Appreciate (B) Depreciate (C) Remain unchanged (D) Become more volatile

2. A decrease in a country's interest rates relative to other countries will cause its currency to: (A) Appreciate (B) Depreciate (C) Remain unchanged (D) Fluctuate wildly

Free Response Question:

Assume the United States and Japan are trading partners. The current exchange rate is 1 USD = 150 JPY. Suppose that the interest rates in the U.S. increase significantly.

(a) Draw a correctly labeled graph of the foreign exchange market for the Japanese Yen, and show the effect of the change in U.S. interest rates on the demand for the Yen. (b) What will happen to the value of the Japanese Yen, relative to the U.S. dollar? Explain. (c) What will happen to the value of the U.S. dollar, relative to the Japanese Yen? Explain. (d) Given your answer to (b), what will happen to Japanese exports to the United States? Explain.

Answer Key:

Multiple Choice:

1. (A)
2. (B)

Free Response Question:

(a) Graph: - Correctly labeled axes with Quantity of Yen on the x-axis and Price of Yen (in USD) on the y-axis. [1 point] - Downward sloping demand curve for Yen and upward sloping supply curve for Yen. [1 point] - Leftward shift of the demand curve for Yen. [1 point]

(b) Value of Yen: - The Yen will depreciate. [1 point] - Explanation: Higher interest rates in the U.S. attract investment, increasing demand for the dollar and decreasing demand for the Yen. [1 point]

(c) Value of Dollar: - The U.S. dollar will appreciate. [1 point] - Explanation: As demand for the dollar increases, its value relative to the Yen increases. [1 point]

(d) Japanese Exports: - Japanese exports to the U.S. will increase. [1 point] - Explanation: A weaker Yen makes Japanese goods cheaper for U.S. consumers, increasing demand for Japanese exports. [1 point]

#🏛️ Fiscal Policy and Exchange Rates

#📈 Expansionary Fiscal Policy

When a government increases spending or cuts taxes, it's using expansionary fiscal policy. This boosts aggregate demand (AD), which increases both real GDP and the price level. Higher prices make a country's goods less attractive to foreign buyers, reducing demand for its currency and causing it to depreciate.

• Example: The US government increases spending. AD increases, prices rise, and the dollar depreciates.
  • 

#📉 Contractionary Fiscal Policy

When a government decreases spending or raises taxes, it's using contractionary fiscal policy. This reduces AD, which decreases both real GDP and the price level. Lower prices make a country's goods more attractive to foreign buyers, increasing demand for its currency and causing it to appreciate.

• Example: The US government decreases spending. AD decreases, prices fall, and the dollar appreciates.
  • 

#🏦 Monetary Policy and Exchange Rates

#⬆️ Expansionary Monetary Policy

When a central bank increases the money supply (by lowering the reserve ratio, lowering the discount rate, or buying bonds), it's using expansionary monetary policy. This lowers interest rates, which increases investment spending and AD. Higher prices make a country's goods less attractive, decreasing demand for its currency and causing it to depreciate.

• Example: The Federal Reserve increases the money supply. Interest rates fall, prices rise, and the dollar depreciates.
  • 

#⬇️ Contractionary Monetary Policy

When a central bank decreases the money supply (by raising the reserve ratio, raising the discount rate, or selling bonds), it's using contractionary monetary policy. This raises interest rates, which decreases investment spending and AD. Lower prices make a country's goods more attractive, increasing demand for its currency and causing it to appreciate.

• Example: The Federal Reserve decreases the money supply. Interest rates rise, prices fall, and the dollar appreciates.
  • 

Practice Question

Multiple Choice:

1. If a country's central bank sells bonds, what is the likely effect on its currency? (A) Appreciate (B) Depreciate (C) Remain unchanged (D) Become more volatile

2. An increase in government spending, without a corresponding increase in taxes, will likely lead to: (A) Currency appreciation (B) Currency depreciation (C) No change in currency value (D) A decrease in interest rates

Free Response Question:

Assume the U.S. economy is in a recession. The Federal Reserve decides to engage in expansionary monetary policy.

(a) Identify one monetary policy action the Federal Reserve could take. (b) Draw a correctly labeled graph of the money market, and show the effect of the policy you identified in part (a) on the nominal interest rate. (c) What will happen to the value of the U.S. dollar, relative to other currencies? Explain. (d) What will happen to U.S. net exports? Explain.

Answer Key:

Multiple Choice:

1. (A)
2. (B)

Free Response Question:

(a) Monetary Policy Action: - The Federal Reserve could buy bonds, lower the discount rate, or lower the reserve requirement. [1 point]

(b) Money Market Graph: - Correctly labeled axes with Quantity of Money on the x-axis and Nominal Interest Rate on the y-axis. [1 point] - Downward sloping demand curve for money and upward sloping supply curve for money. [1 point] - Rightward shift of the money supply curve. [1 point] - Show a decrease in the nominal interest rate. [1 point]

(c) Value of Dollar: - The U.S. dollar will depreciate. [1 point] - Explanation: Expansionary monetary policy lowers interest rates, decreasing demand for the dollar. [1 point]

(d) U.S. Net Exports: - U.S. net exports will increase. [1 point] - Explanation: A weaker dollar makes U.S. goods cheaper for foreign consumers, increasing exports. [1 point]

#🚧 Trade Barriers

#🛡️ Why Trade Barriers?

While most economists agree that free trade is beneficial, trade barriers like tariffs and quotas are often put in place to protect domestic jobs. The idea is that lower-wage countries can produce goods more cheaply, which can lead to job losses in higher-wage countries. 🌍

#💰 Tariffs

Tariffs are taxes on imported goods. There are two main types:

1. Revenue Tariffs: Taxes on goods not produced domestically (like bananas in the US). These are primarily for raising government revenue.
2. Protective Tariffs: Taxes on goods that are also produced domestically. These are designed to protect domestic jobs.

• Impact of Tariffs:

  • Consumers pay higher prices and consume less. 💸
  • Consumer surplus is lost.
  • Domestic producers increase output. 🏭
  • Imports decline.
  • The government gains revenue.
  • Overall inefficiency due to not operating at market equilibrium.

• Tariff Graph Example:

  • 
  • No Tariff:
    • Domestic price is P, world price is P*. Consumers demand Qw, domestic producers supply Qd, and Qw-Qd is imported.
    • 
  • With Tariff:
    • Price increases to P'. Consumers demand less, domestic producers supply more, and imports decrease.
    • 
  • Summary of Tariff Effects:
    • 
    • Demand decreases from Q4 to Q3. Domestic production increases from Q1 to Q2. Price increases from P1 to P2. Government revenue is the cream box.

#🗂️ Quotas

Quotas set a maximum quantity of a good that can be imported. They have similar effects to tariffs, but the government doesn't gain revenue. Instead, the revenue goes to the foreign producers who get to sell their goods at higher prices.

• Quota Graph Example:
  • 
  • Without quotas, demand is Q4, domestic production is Q1, and imports are Q4-Q1. With a quota, supply shifts right, demand is Q3, domestic production is Q2, and imports are Q3-Q2. The price rises from Pworld to Pquota.

Practice Question

Multiple Choice:

1. A tariff on imported steel will likely result in: (A) Lower prices for consumers (B) Increased consumer surplus (C) Increased domestic production of steel (D) Decreased government revenue

2. Compared to a tariff, an import quota: (A) Generates more revenue for the government (B) Results in lower prices for consumers (C) Has a similar impact on domestic production (D) Increases the quantity of imports

Free Response Question:

Suppose the world price of a good is lower than the domestic price in a country. The country is considering imposing a tariff on this good.

(a) Draw a correctly labeled graph showing the domestic supply and demand for the good, as well as the world price. Show the quantity of imports before the tariff. (b) On the same graph, show the effect of imposing a tariff. Indicate the new price, the new quantity of imports, and the area representing government revenue. (c) Explain the impact of the tariff on consumer surplus and producer surplus. (d) What is one argument in favor of imposing this tariff?

Answer Key:

Multiple Choice:

1. (C)
2. (C)

Free Response Question:

(a) Graph: - Correctly labeled axes with Quantity on the x-axis and Price on the y-axis. [1 point] - Downward sloping demand curve and upward sloping supply curve. [1 point] - Horizontal line representing the world price below the equilibrium price. [1 point] - Show the quantity of imports as the difference between domestic demand and supply at the world price. [1 point]

(b) Effect of Tariff: - Show the new price above the world price. [1 point] - Show the new quantity of imports as the difference between domestic demand and supply at the new price. [1 point] - Indicate the area of government revenue as a rectangle. [1 point]

(c) Impact on Surpluses: - Consumer surplus decreases. [1 point] - Producer surplus increases. [1 point]

(d) Argument in Favor: - One argument is to protect domestic jobs. [1 point]

#🎯 Final Exam Focus

#🥇 High-Value Topics

• Foreign Exchange Market: Understanding how changes in demand and supply affect currency values. Pay attention to the determinants of currency shifts, and how they relate to trade and investment flows.
• Fiscal and Monetary Policy: Know how expansionary and contractionary policies impact exchange rates. Be sure to connect these policies to the AD-AS model. 📈
• Trade Barriers: Understand the effects of tariffs and quotas on prices, quantities, and overall welfare. Don't forget to consider the impact on consumer and producer surplus. 📊

#📝 Exam Tips

• Time Management: Don't spend too long on any single question. If you're stuck, move on and come back later. ⏰
• FRQ Structure: Clearly label all parts of your FRQ answers. Use graphs where appropriate, and explain your reasoning thoroughly.
• Common Pitfalls: Avoid confusing fiscal and monetary policies. Be precise with your terminology. Double-check your graphs for accuracy. 🧐
• Connect the Dots: Remember how different concepts are related. For example, how does a change in interest rates affect the exchange rate and net exports? 🤔

#💪 You've Got This!

You've reviewed a ton of material, and you're ready to rock this exam. Stay calm, trust your preparation, and remember all the cool secrets you've uncovered. Good luck! 🍀