Topic 6.4 Notes – Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market

1. How the Foreign Exchange Market Works

The foreign exchange (FOREX) market is where one country’s currency is exchanged for another.

The exchange rate is the price of one currency in terms of another, like 1 U.S. dollar = 0.90 euros.

In a flexible exchange rate system, the price is determined by supply and demand.

Think of the graph below as the market for U.S. dollars measured in Mexican pesos. The vertical axis shows the price of dollars in pesos, and the horizontal axis shows the quantity of dollars.

Foreign exchange market equilibrium for U.S. dollars

Who demands a currency?

Foreigners who want to buy:

• Exports (goods and services)
• Financial assets (stocks, bonds, real estate)

If Chinese consumers want U.S. iPhones, they need dollars. That increases demand for dollars, which shifts the demand curve to the right on the graph.

Who supplies a currency?

Domestic residents who want to buy:

• Imports
• Foreign assets

If Americans buy German cars, they supply dollars to get euros. On the graph, that is a rightward shift of the supply curve for dollars.

Appreciation vs. Depreciation

• Appreciation = currency becomes stronger (exchange rate rises).
• Depreciation = currency becomes weaker (exchange rate falls).

On this graph, appreciation means the price of dollars in pesos rises. Depreciation means the price of dollars in pesos falls.

• Demand ↑ → appreciation
• Supply ↑ → depreciation

On tests, you must say which curve shifts and why. “Demand for dollars increases because foreigners want U.S. bonds” earns points. Just saying “the dollar goes up” does not.

2. What Shifts Currency Demand and Supply

There are four major determinants.

A. Changes in Demand for Exports

If foreigners want more of your goods:

• Demand for your currency ↑
• Currency appreciates

Example: Global tourism to Mexico rises → demand for pesos increases → peso appreciates.

If U.S. export prices rise and foreigners buy less:

• Demand for dollars ↓
• Dollar depreciates

B. Changes in Relative Income

Income affects imports.

If U.S. income rises:

• Americans buy more imports
• Supply of dollars ↑
• Dollar depreciates

If Europe’s income rises:

• They buy more U.S. exports
• Demand for dollars ↑
• Dollar appreciates

C. Changes in Real Interest Rates

Capital flows matter as much as trade flows.

If U.S. real interest rates rise:

• Foreign investors buy U.S. bonds
• Demand for dollars ↑
• Dollar appreciates

This is what happened under Paul Volcker in the early 1980s. The Federal Reserve raised interest rates to fight inflation, and the dollar strengthened sharply.

If interest rates fall, like after the 2008 financial crisis when the Fed cut rates aggressively:

• Foreign investment falls
• Dollar demand decreases
• Dollar depreciates

D. Trade Barriers

Countries use tariffs and quotas to protect domestic jobs.

A tariff is a tax on imports.

• Revenue tariff: placed on goods not produced domestically (raises government revenue).
• Protective tariff: protects domestic producers.

A quota sets a maximum quantity of imports.

If the U.S. imposes a tariff:

• Imports fall
• Americans need less foreign currency
• Supply of dollars decreases
• Dollar appreciates

Protectionism reduces currency supply in FOREX.

3. Fiscal Policy and Exchange Rates

Fiscal policy changes aggregate demand (AD), output, and price level.

Expansionary Fiscal Policy (↑G or ↓T)

Step-by-step:

1. AD increases.
2. Real GDP and price level rise.
3. Domestic goods become more expensive.
4. Exports fall, imports rise.
5. Demand for currency falls (or supply rises).
6. Currency depreciates.

Large government spending, like during the Great Depression’s New Deal, increased AD. In general, higher price levels reduce export competitiveness.

Contractionary Fiscal Policy (↓G or ↑T)

1. AD decreases.
2. Price level falls.
3. Exports rise.
4. Demand for currency increases.
5. Currency appreciates.

Lower domestic prices make exports more attractive.

4. Monetary Policy and Exchange Rates

Monetary policy mainly works through interest rates.

Expansionary Monetary Policy

The Federal Reserve buys bonds, lowers the reserve ratio, or lowers the discount rate.

Effects:

• Money supply ↑
• Interest rates ↓
• Foreign investment ↓
• Demand for currency ↓
• Currency depreciates

Lower rates after 2008 put downward pressure on the dollar.

Contractionary Monetary Policy

Fed sells bonds or raises rates.

Effects:

• Money supply ↓
• Interest rates ↑
• Foreign investment ↑
• Demand for currency ↑
• Currency appreciates

Again, think Volcker era and the strong dollar.

5. How to Explain FOREX Changes on Exams

Your answer should follow this chain:

1. Identify determinant (income, interest rate, trade policy, fiscal policy).
2. State which curve shifts.
3. State direction.
4. Conclude appreciation or depreciation.

Quick reference: