Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- Demand for valdas shifts when foreigners want more or fewer Valdorian goods, services or assets: foreign tastes, foreign incomes, relative price levels, relative interest rates, expectations.
- Supply of valdas shifts when Valdorians want more or fewer foreign goods, services or assets: Valdorian tastes, Valdorian incomes, relative price levels, relative interest rates, and tariffs or quotas on the other country’s goods.
- One event can shift both curves. Higher Valdorian inflation: demand for valdas down and supply up, so the valda depreciates.
- Fiscal policy: deficit-financed expansion → more government borrowing → real interest rate rises → demand for the currency rises → appreciation. Contraction does the opposite.
- Monetary policy: expansion → interest rate falls → demand for the currency falls (and supply rises) → depreciation. Contraction → appreciation.
- When one currency appreciates, the other depreciates.
Key relationships
| Change in Valdoria (or Ostria) | Market for valdas | Valda |
|---|---|---|
| Ostrian incomes or tastes for Valdorian goods rise | Demand ↑ | Appreciates |
| Valdorian incomes rise | Supply ↑ | Depreciates |
| Valdoria’s inflation above Ostria’s | Demand ↓, supply ↑ | Depreciates |
| Valdorian interest rates rise relative to Ostria’s | Demand ↑ (supply ↓) | Appreciates |
| Valdorian tariff or quota on Ostrian goods | Supply ↓ | Appreciates |
| Expansionary monetary policy in Valdoria | Demand ↓ (supply ↑) | Depreciates |
| Deficit-financed expansionary fiscal policy in Valdoria | Demand ↑ (via higher real interest rate) | Appreciates |
Assumptions behind the model
- Exchange rates are flexible, and financial capital can move between the two countries.
- Each shift is analysed with everything else held constant.
- Fiscal policy questions use the interest-rate chain unless the question asks about incomes or prices and imports.
Mistakes to avoid
- Saying higher domestic incomes raise demand for the domestic currency. They raise its supply (more imports).
- Shifting demand for a tariff on imports. The tariff cuts the supply of the domestic currency.
- Saying expansionary monetary policy makes the currency appreciate.
- Forgetting to state the effect on the other currency.
- Claiming a definite change in quantity when demand and supply shift in opposite directions.
- Going on to net exports when the question only asks about the exchange rate.
Quick self-check
Valdoria (currency: valda, VD) and Ostria (currency: ostro, OS) are the fictional countries used in the study guide.
- Valdoria’s central bank raises interest rates. What happens to the valda? (It appreciates: demand for valdas increases.)
- Ostrian incomes fall. Which curve shifts, and what happens to the valda? (Demand for valdas decreases; the valda depreciates.)
- The valda rises from OS 1.5 to OS 1.8. By what percentage do the valda and the ostro change? (Valda +20%; ostro −16.67%.)
Next: practice questions.