The Foreign Currency Market
AP Annual Conference 2012
Orlando, Florida
Arthur Raymond
Chief Reader, AP Macroeconomics
Muhlenberg College
Allentown, PA
Confidential and Proprietary –
Not for Distribution
1
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
2
Labeling the Axes
• The diagram below shows supply and demand
in the auto market.
Scars
Dcars
3
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
4
Labeling the Axes
• The diagram below shows supply and demand
for Euros in the foreign currency market.
S€
D€
5
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.,
$1.25/1€
6
Labeling the Axes
• The diagram below shows supply and demand
for dollars on the foreign currency market.
S$
D$
7
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/ $1
8
Labeling the Axes
• The diagram below shows the supply and
demand for Yen in the foreign currency market.
S¥
D¥
9
Labeling the Axes
• What is the label on the horizontal axis?
Quantity of Yen
• What is the label on the vertical axis if it’s the
Euro-Yen market?
Euro per Yen, €/¥1, i.e,
€.0103/¥1
10
Labeling the Axes
In the foreign currency market, the vertical
axis is the price of one unit of the currency on
the horizontal axis.
11
Slopes of Supply and Demand
Curves for Currency
€/$
S$
Dollar-Euro Market
D$
Q$
12
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.
13
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.
14
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).
15
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
16
Shifts of the Demand and Supply
Curves for Currency
1. (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.
17
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.
18
Shifts of the Demand and Supply
Curves for Currency
$/¥
S¥
($/¥)1
($/¥)2
D’¥
D¥
Q¥
19
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.
20
Shifts of the Demand and Supply
Curves for Currency
$/€
S’€
S€
($/€)2
($/€)1
D’€
D€
Q€
21
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)
22
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.
23
Shifts of the Demand and Supply
Curves for Currency
$/b
Sb
S’b
($/b)1
($/b)2
Db
Qb
24