The foreign exchange market is where one currency is traded for another. In AP Macroeconomics you draw it like any supply and demand graph, with one twist: the price is the exchange rate, and you must say which currency is being priced. On a graph for the market for dollars, the vertical axis is the price of a dollar in another currency, such as pounds per dollar, and the horizontal axis is the quantity of dollars.
Demand for dollars comes from people abroad who want US goods, services and assets. Supply of dollars comes from people in the United States who want foreign goods, services and assets, because they sell dollars to buy other currencies. When demand for dollars rises, the dollar appreciates. When supply of dollars rises, the dollar depreciates. Educational only, not investment advice, and no live exchange rates are shown.
How to draw the foreign exchange graph
- Title the graph the market for one currency, for example the market for US dollars.
- Label the vertical axis as the price of that currency in the other one, for example pounds per dollar. Label the horizontal axis the quantity of dollars.
- Draw demand sloping down and supply sloping up, and mark the equilibrium exchange rate.
- Shift one curve, mark the new rate, and state whether the currency appreciated or depreciated.
What shifts demand and supply
| Change | Market for dollars | Effect on the dollar |
|---|---|---|
| US real interest rates rise compared with abroad | Demand for dollars rises, as foreign savers buy US assets | Appreciates |
| Foreign incomes rise | Demand for dollars rises, as foreigners buy more US exports | Appreciates |
| US incomes rise | Supply of dollars rises, as Americans buy more imports | Depreciates |
| US price level rises compared with abroad | US goods look dearer, so demand for dollars falls and supply rises | Depreciates |
| Tastes shift toward US products | Demand for dollars rises | Appreciates |
The interest rate row links this page to the loanable funds market. In an open economy, a higher real interest rate draws in financial capital, and that inflow is the extra demand for the currency.
The two graph rule
A shift in the market for dollars against pounds has a mirror image in the market for pounds against dollars. If demand for dollars rises, Americans are not changing their plans, but foreigners must sell pounds to buy dollars, so the supply of pounds rises. The dollar appreciates and the pound depreciates. On an exam, if you are asked to show both, shift demand in one graph and supply in the other.
Appreciation, net exports and aggregate demand
When the dollar appreciates, US exports become dearer for foreign buyers and imports become cheaper for US buyers. Net exports fall, so aggregate demand in the United States shifts left. A depreciation raises net exports and shifts aggregate demand right. Follow that last step on the aggregate demand and aggregate supply explainer. Why market rates can stray far from a price based benchmark is on the exchange rates and purchasing power parity page, and the accounting of these flows is on the balance of payments page.
Common AP exam mistakes
- Writing only exchange rate on the vertical axis without saying which currency is priced in which.
- Shifting supply of dollars when foreigners want more US goods. Foreign buyers demand dollars.
- Saying a stronger currency raises net exports. It lowers them.
- Shifting the same type of curve in both currency graphs.
Short definitions sit in the glossary under real interest rate. The unit list is on the AP Macro review hub.
Sources
- College Board, AP Macroeconomics course page, Unit 6 Open Economy
- Federal Reserve, H.10 Foreign Exchange Rates release
- Bank of England, Statistics
Common questions
What shifts the demand for a currency in AP Macro?
Higher relative interest rates in that country, higher incomes abroad, a lower relative price level, and stronger foreign tastes for that country's goods all raise demand for its currency. Each of these makes foreigners want more of its goods or assets.
Does a currency appreciation raise or lower net exports?
It lowers them. Exports become dearer to foreign buyers and imports become cheaper at home, so net exports fall and aggregate demand shifts left.
How do I label the foreign exchange market graph?
Title it the market for one currency. Put the price of that currency in the other currency on the vertical axis, such as pounds per dollar, and the quantity of that currency on the horizontal axis.
How do higher US interest rates affect the dollar?
Higher US real interest rates attract foreign financial capital. Foreigners demand dollars to buy US assets, so demand for dollars shifts right and the dollar appreciates.