Topic 6.5 Notes – Changes in the Foreign Exchange Market and Net Exports

1. How Currency Appreciation and Depreciation Work

In a flexible exchange rate system, exchange rates are determined by supply and demand in the foreign exchange (FOREX) market.

• Demand for a currency comes from foreigners who want:
  • That country’s exports
  • That country’s financial assets (stocks, bonds, real estate)
• Supply of a currency comes from domestic residents who want:
  • Imports
  • To invest abroad

Appreciation

Appreciation means a currency becomes stronger relative to another currency.

• It takes more foreign currency to buy it.
• Caused by:
  • ↑ Demand for the currency (rightward shift of demand)
  • ↓ Supply of the currency (leftward shift of supply)

Example: If the U.S. raises interest rates, foreign investors buy more U.S. Treasury bonds. They need dollars to do that → demand for dollars rises → the dollar appreciates.

Depreciation

Depreciation means a currency becomes weaker.

• It takes less foreign currency to buy it.
• Caused by:
  • ↓ Demand for the currency
  • ↑ Supply of the currency

Example: During a trade war with tariffs on Canadian goods, foreigners may buy fewer Canadian exports. Demand for the Canadian dollar falls → the Canadian dollar depreciates.

The graph below shows an appreciation caused by an increase in demand.

FOREX market: demand increase causing appreciation

Notice the rightward shift of the demand curve from D to D₁. The equilibrium price rises from P to P₁ and quantity increases from Q to Q₁, which represents the currency appreciating.

Always describe shifts of curves, not movements along curves. The AP graders look for that language.

2. How Exchange Rates Affect Exports, Imports, and Net Exports

Remember:

$$\text{Net Exports (NX)} = \text{Exports} - \text{Imports}$$

Exchange rates change relative prices between countries.

When a Currency Appreciates

• Domestic goods become more expensive to foreigners
  → Exports decrease
• Foreign goods become cheaper to domestic consumers
  → Imports increase
• Result: Net Exports decrease

Real-world anchor: When the U.S. dollar is strong, American goods are more expensive abroad. U.S. consumers buy more imported goods. The U.S. trade deficit often widens.

Tourism example: If the Mexican peso appreciates, vacations in Mexico become more expensive for foreigners → fewer tourists → exports of services fall.

When a Currency Depreciates

• Domestic goods become cheaper to foreigners
  → Exports increase
• Foreign goods become more expensive to domestic consumers
  → Imports decrease
• Result: Net Exports increase

This is why many developing countries sometimes prefer a weaker currency. It makes their exports more competitive globally.

Quick summary:

Memorize this pattern. It shows up constantly in multiple choice and FRQs.

3. From Net Exports to Aggregate Demand

Aggregate demand is:

$$\text{AD} = C + I + G + (X - M)$$

That last term is net exports. So any change in exports or imports shifts the entire AD curve.

If Net Exports Decrease (from appreciation)

• AD shifts left
• Real GDP falls
• Employment falls
• Unemployment rises
• Downward pressure on the price level

Leftward shift of aggregate demand

If Net Exports Increase (from depreciation)

• AD shifts right
• Real GDP rises
• Employment rises
• Unemployment falls
• Upward pressure on the price level (demand-pull inflation)

Rightward shift of aggregate demand

Think through the chain. Exchange rate → exports/imports → net exports → AD → output and price level.

4. Connecting FOREX and AD-AS on the Exam

You’re often asked to show this as a sequence.

Appreciation Chain

1. Demand for currency increases
2. Currency appreciates
3. Exports fall, imports rise
4. Net exports decrease
5. AD shifts left
6. Output decreases, unemployment increases

Depreciation Chain

1. Demand for currency decreases
2. Currency depreciates
3. Exports rise, imports fall
4. Net exports increase
5. AD shifts right
6. Output increases, unemployment decreases

If interest rates rise due to contractionary monetary policy, capital inflows can cause appreciation. That can partially offset the policy by reducing net exports. That connection sometimes appears in more challenging questions.