1. The Foreign Currency Market
AP Annual Conference 2012
Orlando, Florida
Arthur Raymond
Chief Reader, AP Macroeconomics
Muhlenberg College
Allentown, PA

2. The Foreign Currency Market
Proper Labeling of the Axes of the foreign currency market diagram
The slopes of the demand and supply curves for foreign currency
Shifts of the demand and supply curves for foreign currency

3. Labeling the Axes
The diagram below shows supply and demand in the auto market.
Scars
Dcars

4. The price of one car: $/1car
Labeling the Axes
What is the label on the horizontal axis of the diagram for the auto market?
The quantity of cars
What is the label on the vertical axis of the diagram for the auto market?
The price of one car: $/1car

5. Labeling the Axes
The diagram below shows supply and demand for Euros in the foreign currency market. S€ D€

6. Labeling the Axes What is the label on the horizontal axis?
The quantity of Euros
What is the label on the vertical axis?
The price of one Euro
If it’s the dollar-euro market, then it’s the number of dollars to buy one Euro, i.e., $1.25/1€

7. Labeling the Axes
The diagram below shows supply and demand for dollars on the foreign currency market. S$ D$

8. The quantity of dollars
Labeling the Axes
What is the label on the horizontal axis?
The quantity of dollars
What is the label on the vertical axis?
The price of one dollar
If it’s the dollar-euro market, then it’s the number of Euros to buy one dollar, €/$, i.e., €0.80/ $1

9. Labeling the Axes
The diagram below shows the supply and demand for Yen in the foreign currency market. S¥
D ¥

10. Labeling the Axes What is the label on the horizontal axis?
Quantity of Yen
What is the label on the vertical axis if it’s the Euro-Yen market?
Euro per Yen, €/¥1, i.e,
€.0103/¥1

11. Labeling the Axes
In the foreign currency market, the vertical axis is the price of one unit of the currency on the horizontal axis.

12. Slopes of Supply and Demand Curves for Currency
€/$ S$
Dollar-Euro Market D$ Q$

13. Slopes of Supply and Demand Curves for Currency
The demand for the dollar on the dollar-euro market is due to the European demand for US goods, services, and financial assets.

14. Slopes of Supply and Demand Curves for Currency
Given an exchange rate, say €1/$1, what effect does an increase in the exchange rate to, say, €2/$1 have on:
The price of US Goods and Services expressed in Euros?
Euro Price Increases
The Demand for US Goods and Services?
Demand for US Goods (US exports) decreases
The Demand for US currency?
Quantity Demanded of US Currency Decreases

15. Slopes of Supply and Demand Curves for Currency
Conclusion:
An increase in the euro price of the dollar produces a decrease in the quantity demanded of US currency.
The demand for US currency is downward sloping.

16. Slopes of Supply and Demand Curves for Currency
The supply of the dollar on the Dollar-Euro market is due to US demand for European goods, services, and financial assets.

17. Slopes of Supply and Demand Curves for Currency
Given an exchange rate, say €1/$1, what effect does an increase in the exchange rate to, say, €2/$1 have on:
The price of European Goods and Services expressed in Dollars?
Dollar Price Decreases
The Demand for European Goods and Services?
Demand for European Goods (US Imports) Increases
The quantity supplied of US currency
The quantity supplied of US Currency Increases

18. Slopes of Supply and Demand Curves for Currency
Conclusion:
An increase in the euro price of the dollar produces an increase in the quantity supplied of US currency.
The supply of US currency is upward sloping.

19. Shifts of the Demand and Supply Curves for Currency
Shifts of the Supply or Demand Curves for Currency Produce Appreciation or Depreciation of a Currency (with floating exchange rates).

20. Shifts of the Demand and Supply Curves for Currency
Sources of shifts in currency demand and supply curves
Changes in price levels
Changes in real interest rates
Changes in real income

21. Shifts of the Demand and Supply Curves for Currency
(a) Explain the effect of a decrease in the US price level on the demand for the Japanese Yen.
A decrease in the US Price level will decrease the demand for Japanese goods and services and increase the demand for US goods and services, so there will be a decrease in the demand for the Japanese Yen.

22. Shifts of the Demand and Supply Curves for Currency
(b) Use a properly labeled graph of the foreign exchange market for the Japanese Yen to show the effect of the change in demand for the Japanese Yen described in part (a) on the dollar value of the Yen.

23. Shifts of the Demand and Supply Curves for Currency
$/¥ S¥
($/¥)1
($/¥)2
D’¥ D¥ Q¥

24. Shifts of the Demand and Supply Curves for Currency
(From 2007 Macroeconomics Exam, Form B)
Assume that the interest rate in both the United States and the European Union equals 4.5 percent.
a) Assume that the real interest rate in the United States falls to 3.75 percent.
(ii) Using a correctly labeled graph of the foreign exchange market for the euro, show how the value of the euro would change relative to the United States dollar in a flexible exchange rate system.

25. Shifts of the Demand and Supply Curves for Currency
$/€ S€
($/€)2
($/€)1
D’€ D€ Q€

26. Shifts of the Demand and Supply Curves for Currency
(From 2012 AP Macroeconomics Exam)
(c) Suppose Rankinland has a current account deficit. Rankinland’s currency is called the bera.
(i) What will initially happen to the current account deficit in Rankinland solely due to the change in the real GDP from part (b)(iv) ? Explain.
(ii) What will happen to the international value of the bera solely due to the change in the real GDP from part (b)(iv) ? Explain.
(Real GDP Increases)

27. Shifts of the Demand and Supply Curves for Currency
An increase in Real GDP increases Rankinland’s imports, which increases the supply of the bera on the foreign exchange market. An increase in the supply of the bera will cause a decrease in the value of the bera.

28. Shifts of the Demand and Supply Curves for Currency
$/b Sb
S’b
($/b)1
($/b)2 Db Qb 28