AP Macroeconomics · Unit 6 · Topic 6.3

The Foreign Exchange Market Study Lab

In the foreign exchange market, people trade one currency for another so they can buy goods, services, and assets from another country. Every trade shows up in two markets at once: when Europeans buy dollars, they sell euros. Change who is buying what below and watch the market for dollars and the market for euros move as mirror images.

1. Two linked currency markets

The page starts at 0.80 euros per dollar, which is the same as 1.25 dollars per euro. Dashed grey lines show where each market started. Solid lines show where it is now.

Market for U.S. dollars price of the dollar in euros

Market for euros price of the euro in dollars

Demand for the currencySupply of the currencyStarting position
Try a scenario
Shifts demand for dollars and supply of euros
Shifts supply of dollars and demand for euros
Euros per dollar
0.80
Dollars per euro
1.25
The dollar
No change
The euro
No change

2. Key ideas

Demand

Who demands dollars

Foreigners who want to buy U.S. goods, services, and assets. A European tourist in New York, a French firm buying U.S. software, and a German investor buying U.S. bonds all need dollars first.

Supply

Who supplies dollars

Americans who want to buy foreign goods, services, and assets. To pay for a German car or a French stock, an American trades dollars away for euros.

One trade, two markets

The mirror image

Trading euros for dollars is buying dollars and selling euros at the same time. An increase in demand for dollars is an increase in supply of euros. An increase in supply of dollars is an increase in demand for euros.

Read the axis

Appreciation and depreciation

On the dollar graph, a higher number of euros per dollar means the dollar appreciates: one dollar buys more euros. The euro depreciates by the same move, so dollars per euro falls.

Reciprocal

Two quotes, one rate

Dollars per euro is 1 divided by euros per dollar. If 1 dollar buys 0.80 euros, then 1 euro buys 1 ÷ 0.80 = 1.25 dollars.

Shift or move

What moves the curves

A change in the exchange rate itself is a movement along the curves. A change in how much people want to buy from the other country shifts a curve in each market.

3. Who buys what: the cheat sheet

Each event shifts one curve in the dollar market and the matching curve in the euro market. Memorize the pairs.

EventMarket for dollarsMarket for eurosDollarEuro
Europeans buy more U.S. goods and services (U.S. exports rise)Demand rightSupply rightAppreciatesDepreciates
European investors buy more U.S. stocks and bondsDemand rightSupply rightAppreciatesDepreciates
Americans buy more European goods and services (U.S. imports rise)Supply rightDemand rightDepreciatesAppreciates
Americans buy more European stocks and bondsSupply rightDemand rightDepreciatesAppreciates
Europeans buy fewer U.S. goods or assetsDemand leftSupply leftDepreciatesAppreciates
Americans buy fewer European goods or assetsSupply leftDemand leftAppreciatesDepreciates

4. Drawing it on the FRQ

Labels that earn points

  • Title the graph with the currency you are graphing, such as "Market for U.S. dollars."
  • Horizontal axis: Quantity of dollars. Vertical axis: the price of the dollar in the other currency, Euros per dollar. For the euro market, use Quantity of euros and Dollars per euro.
  • Label the curves D$ and S$. Draw the new curve, label it D$2 or S$2, and add an arrow for the direction of the shift.
  • Mark the starting and new exchange rates on the vertical axis (ER1 and ER2) and the quantities on the horizontal axis.
  • Name the cause in words: "Demand for dollars increases because Europeans need dollars to buy U.S. goods."
  • Use the CED words: "the dollar appreciates relative to the euro" and "the euro depreciates relative to the dollar."

Common mistakes

  • Putting the wrong currency on the vertical axis. The dollar graph needs the price of a dollar (euros per dollar), not dollars per euro.
  • Shifting demand for dollars when Americans buy imports. Americans buying foreign goods supply dollars and demand the foreign currency.
  • Saying both currencies appreciate. If the dollar appreciates against the euro, the euro must depreciate against the dollar.
  • Shifting both curves in one market when only one group's behavior changed. A single purchase decision, such as Europeans buying more U.S. goods, shifts one curve in the dollar market and the mirror curve in the euro market. Some events, like relative inflation, change both groups' behavior and shift both curves.
  • Calling a change in the exchange rate a shift. The rate moving is a movement along the curves.

5. Practice questions

AP-style multiple choice. Pick an answer to see the explanation.

0 / 0 correct

6. Key terms

The vocabulary for topic 6.3. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 6 terminology guide.