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

Jackson Hernandez

Jackson Hernandez

12 min read

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Study Guide Overview

This AP Macroeconomics study guide covers the foreign exchange (FOREX) market, fiscal policy, monetary policy, and trade barriers. It explains how supply and demand influence currency values, the effects of expansionary/contractionary fiscal and monetary policies on exchange rates, and the impact of tariffs and quotas. The guide also includes practice questions and exam tips.

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. 💰
Key Concept

Remember, currency appreciation means a currency becomes more valuable, while depreciation means it becomes less valuable. It's all about supply and demand!

Let's walk through some scenarios:

  • Scenario #1: Tourists flock to Mexico 🇲🇽

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

  • Scenario #2: US export prices rise 📈

    • Demand for US goods decreases, leading to decreased demand for the US dollar (leftward shift). The dollar depreciates.
    • Dollar Demand Decrease

  • Scenario #3: Chinese consumers buy more German goods 🇩🇪

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

  • 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.
    • Yen Demand Increase
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] ...