The value of the dollar moves when something changes how many dollars foreigners want to buy or how many dollars Americans want to sell. Relative interest rates, relative price levels, relative incomes, tastes, expectations, and government policy all shift those curves. Pick an event, watch which curve shifts in the market for dollars, and follow the chain from the cause to appreciation or depreciation.
The market starts at €0.90 per dollar. Dashed grey lines show the starting curves. Solid lines show the market after the event.
Foreigners demand dollars to buy U.S. exports, U.S. stocks and bonds, and U.S. real assets. Americans supply dollars when they trade them for foreign currency to buy imports and foreign assets. Ask who is trading and which way, then shift that curve.
A higher U.S. real interest rate relative to rates abroad makes U.S. financial assets more attractive. Foreign financial capital flows in, demand for dollars rises, and the dollar appreciates. A lower relative rate does the reverse.
Higher U.S. inflation relative to abroad makes U.S. goods pricier, so demand for dollars falls and supply rises: the dollar depreciates. Higher U.S. income means more imports, so supply of dollars rises and the dollar depreciates. Higher foreign income means more U.S. exports and a stronger dollar.
If foreigners come to prefer U.S. goods, demand for dollars rises. If traders expect the dollar to appreciate later, speculators buy dollars now, which raises demand and appreciates the dollar today.
Contractionary monetary policy and deficit-financed expansionary fiscal policy both raise the U.S. real interest rate, attract foreign financial capital, and appreciate the dollar. Expansionary monetary policy lowers the interest rate and depreciates the dollar.
If the dollar appreciates against the euro, the euro depreciates against the dollar. In the market for euros, an increase in demand for dollars shows up as an increase in the supply of euros, because Europeans sell euros to get dollars.
Each row follows the AP chain: event, who buys or sells dollars, which curve shifts, and what happens to the dollar.
| Event (U.S. relative to Europe) | Who buys or sells dollars | Market for dollars | U.S. dollar | Euro |
|---|---|---|---|---|
| U.S. real interest rate rises | Foreigners buy more U.S. financial assets | Demand right | Appreciates | Depreciates |
| U.S. price level rises faster than abroad | Foreigners buy fewer U.S. goods; Americans buy more imports | Demand left, supply right | Depreciates | Appreciates |
| U.S. income rises | Americans buy more imports | Supply right | Depreciates | Appreciates |
| European income rises | Europeans buy more U.S. exports | Demand right | Appreciates | Depreciates |
| Foreign tastes shift toward U.S. goods | Foreigners buy more U.S. exports | Demand right | Appreciates | Depreciates |
| Traders expect the dollar to appreciate | Speculators buy dollars now | Demand right | Appreciates | Depreciates |
| Contractionary monetary policy (Fed sells bonds or raises its policy rate) | Interest rate rises; foreigners buy U.S. bonds | Demand right | Appreciates | Depreciates |
| Expansionary monetary policy (Fed buys bonds or lowers its policy rate) | Interest rate falls; foreigners buy fewer U.S. bonds | Demand left | Depreciates | Appreciates |
| Expansionary fiscal policy with deficit borrowing | Real interest rate rises; foreigners buy U.S. bonds | Demand right | Appreciates | Depreciates |
| U.S. tariff or import quota | Americans buy fewer imports | Supply left | Appreciates | Depreciates |
| Central bank sells foreign reserves to buy dollars | Central bank buys dollars | Demand right | Appreciates | Depreciates |
| Central bank sells dollars to buy foreign reserves | Central bank sells dollars | Supply right | Depreciates | Appreciates |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 6.4. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 6 terminology guide.