Policies, Economic Conditions and the Foreign Exchange Market: Study Guide (Macroeconomics 6.4)

From movements to shifts

In Topic 6.3 you drew the market for a currency and found the equilibrium exchange rate. A change in the exchange rate itself moved us along the curves. Now we ask what shifts the curves. When a curve shifts, the market moves to a new equilibrium with a new exchange rate.

We keep the same two fictional countries. Valdoria uses the valda (VD) and Ostria uses the ostro (OS). In the market for valdas, the vertical axis is the exchange rate in ostros per valda and the horizontal axis is the quantity of valdas. All data on this page are fictional.

The rule you will use again and again:

• Demand for valdas increases or supply of valdas decreases → the valda appreciates (and the ostro depreciates).
• Demand for valdas decreases or supply of valdas increases → the valda depreciates (and the ostro appreciates).

What shifts the demand for a currency

Demand for valdas comes from people who want Valdorian goods, services and financial assets. Anything that changes how much of these they want, at every exchange rate, shifts the demand curve.

• Tastes and preferences. If Valdorian olive oil becomes fashionable in Ostria, or more Ostrians want to holiday in Valdoria, demand for valdas increases.
• Foreign incomes. If Ostrian incomes rise, Ostrians buy more of everything, including Valdorian exports. Demand for valdas increases.
• Relative price levels. If Valdoria’s inflation rate is higher than Ostria’s, Valdorian goods become relatively dearer. Ostrians buy fewer of them, so demand for valdas decreases.
• Relative interest rates. If interest rates in Valdoria rise relative to Ostria, Valdorian bonds and bank deposits pay more. Foreign savers want more Valdorian assets, so demand for valdas increases.
• Expectations. If traders expect the valda to appreciate soon, they buy valdas now, and demand increases.

What shifts the supply of a currency

Supply of valdas comes from Valdorians who want foreign goods, services and assets. The same list works in mirror image.

• Tastes and preferences. If Valdorians come to prefer Ostrian cars, they need more ostros, so the supply of valdas increases.
• Domestic incomes. If Valdorian incomes rise, Valdorians buy more imports. The supply of valdas increases.
• Relative price levels. If Valdoria’s inflation is higher than Ostria’s, Ostrian goods look relatively cheap to Valdorians. They import more, so the supply of valdas increases.
• Relative interest rates. If Ostrian interest rates rise relative to Valdoria’s, Valdorians buy more Ostrian assets. The supply of valdas increases.
• Trade barriers. If Valdoria puts a tariff (a tax on imports) or a quota (a limit on the quantity of imports) on Ostrian goods, Valdorians buy fewer Ostrian goods. They need fewer ostros, so the supply of valdas decreases and the valda appreciates.

Notice that one event often moves both curves in directions that push the rate the same way. Higher Valdorian inflation decreases demand for valdas and increases supply of valdas: both make the valda depreciate. On a graph you may show one shift if the question asks for one, but your explanation must give the right direction.

Summary table

Event	Curve in the market for valdas	Valda	Ostro
Ostrian tastes shift toward Valdorian goods	Demand increases	Appreciates	Depreciates
Ostrian incomes rise	Demand increases	Appreciates	Depreciates
Valdorian incomes rise	Supply increases	Depreciates	Appreciates
Valdoria’s inflation is higher than Ostria’s	Demand decreases and supply increases	Depreciates	Appreciates
Valdorian interest rates rise relative to Ostria’s	Demand increases (and supply decreases)	Appreciates	Depreciates
Valdoria puts a tariff or quota on Ostrian goods	Supply decreases	Appreciates	Depreciates

Worked example 1: a rise in Valdoria’s interest rate

Question. In the market for valdas, quantity demanded is Qd = 210 − 60e and quantity supplied is Qs = −30 + 60e, where e is in ostros per valda and quantities are millions of valdas a month. (a) Find the initial equilibrium. (b) Valdorian interest rates rise relative to Ostrian rates, and foreign savers now want 36 million more valdas a month at every exchange rate. Find the new equilibrium. (c) Find the shortage at the old rate before the market adjusts. (d) Calculate the percentage changes in the values of both currencies.

(a) 210 − 60e = −30 + 60e, so 240 = 120e and e = OS 2.0. Quantity = 210 − 120 = 90 million valdas.

(b) New demand: Qd = 246 − 60e. Set 246 − 60e = −30 + 60e, so 276 = 120e and e = OS 2.3. Quantity = 246 − 138 = 108 million valdas.

(c) At OS 2.0, the new quantity demanded is 246 − 120 = 126 million, but the quantity supplied is still 90 million. There is a shortage of 36 million valdas. Buyers bid the valda up until the shortage disappears at OS 2.3.

(d) Valda: (2.3 − 2.0) ÷ 2.0 × 100 = 15% appreciation. Ostro: it falls from 1 ÷ 2.0 = VD 0.50 to 1 ÷ 2.3 = VD 0.4348, so (0.4348 − 0.50) ÷ 0.50 × 100 = 13.04% depreciation.

Interpretation. Higher returns on Valdorian assets attract financial capital into Valdoria. Foreign savers need valdas to buy those assets, so the demand curve shifts right, and both the exchange rate and the quantity of valdas traded rise.

Fiscal policy and the exchange rate

Fiscal policy changes government spending and taxes. It changes aggregate demand, real output and the price level, and through these it can change the exchange rate.

The chain the course usually expects runs through the real interest rate:

1. Valdoria’s government increases spending or cuts taxes, and borrows to finance the larger budget deficit.
2. Government borrowing increases the demand for loanable funds, so Valdoria’s real interest rate rises.
3. Valdorian bonds and deposits now pay more than similar Ostrian assets. Foreign savers want more Valdorian assets, so the demand for valdas increases.
4. The valda appreciates; the ostro depreciates.

Contractionary fiscal policy (less spending or higher taxes) reduces government borrowing, lowers the real interest rate, decreases demand for valdas and makes the valda depreciate.

Watch the other channels. Expansionary fiscal policy also raises Valdorian incomes and, if the economy is near full employment, the price level. Higher incomes and prices lead Valdorians to buy more imports, which increases the supply of valdas and pushes the valda down. Exam questions normally tell you which link to follow. If a question asks you to work through the interest rate, use the four-step chain above. If it asks about the effect of higher incomes or a higher price level on imports, follow that link instead.

Monetary policy and the exchange rate

Monetary policy changes the money supply and interest rates. In the short run a central bank can move the domestic interest rate, and that changes the attractiveness of the country’s financial assets.

Expansionary monetary policy in Valdoria:

1. The central bank uses its tools to lower interest rates (for example, by buying government bonds or lowering its administered rates).
2. Valdorian interest rates fall relative to Ostrian rates, so Valdorian assets are less attractive.
3. Foreign savers want fewer Valdorian assets, so the demand for valdas decreases. Valdorians also move savings into Ostrian assets, so the supply of valdas increases.
4. The valda depreciates; the ostro appreciates.

Contractionary monetary policy raises interest rates, increases demand for valdas (and reduces supply) and makes the valda appreciate.

Monetary policy also changes aggregate demand, real output and the price level. A looser policy that raises Valdoria’s price level relative to Ostria’s adds to the depreciation, so the channels point the same way.

Worked example 2: tracing three events

Question. For each event, state which curve shifts in the market for valdas, the direction, and the effect on the value of the valda and of the ostro. In part (c), find the new equilibrium using the equations from Worked example 1.

(a) Valdoria’s central bank sells government bonds to fight inflation. (b) Valdoria places a quota on imported Ostrian bicycles. (c) Valdoria recovers from a recession. Higher Valdorian incomes mean Valdorians want 24 million more valdas’ worth of Ostrian goods and services each month at every exchange rate.

(a) Selling bonds is contractionary monetary policy. Valdorian interest rates rise, so foreign demand for Valdorian assets rises. Demand for valdas increases (and Valdorians’ supply of valdas for foreign assets falls). The valda appreciates; the ostro depreciates.

(b) The quota limits imports of Ostrian bicycles, so Valdorians need fewer ostros. The supply of valdas decreases. The valda appreciates; the ostro depreciates. (In the market for ostros, the same event is a decrease in the demand for ostros.)

(c) Higher incomes raise imports, so the supply of valdas increases by 24 million: Qs = −6 + 60e. Set 210 − 60e = −6 + 60e, so 216 = 120e and e = OS 1.8, with 210 − 108 = 102 million valdas traded. At the old rate of OS 2.0 there would be a surplus of (−6 + 120) − 90 = 24 million valdas. The valda depreciates by (1.8 − 2.0) ÷ 2.0 × 100 = 10%. One ostro rises from VD 0.50 to 1 ÷ 1.8 = VD 0.5556, an appreciation of 11.11%.

Check. In each part, the valda and the ostro move in opposite directions. Shifts that raise demand or cut supply always raise the price of the currency.

When two things change at once

Some events shift both curves. A rise in Valdorian interest rates increases demand for valdas and decreases supply. Both shifts raise the exchange rate, so the valda certainly appreciates. But demand rising pushes the quantity up while supply falling pushes it down, so the change in the quantity of valdas traded is uncertain unless you know the sizes of the shifts.

The same logic applies to two separate events. If both push the rate the same way, the direction of the rate is certain. If they push it in opposite directions, the rate change is uncertain, and you should say so.

Common misconceptions

• “Higher Valdorian incomes increase demand for valdas.” Valdorian incomes raise Valdorians’ spending on imports, which increases the supply of valdas. It is foreign incomes that raise demand for valdas.
• “A tariff on imports increases demand for the currency.” A tariff or quota on Ostrian goods decreases the supply of valdas, because Valdorians need fewer ostros. The valda still appreciates, but the curve that shifts is supply.
• “Expansionary monetary policy makes the currency appreciate.” It lowers interest rates, so the currency depreciates.
• Mixing up the two currencies. If the valda appreciates, the ostro depreciates. Name both if the question asks.
• Shifting a curve because the exchange rate changed. The exchange rate is the price on the vertical axis. A change in it alone is a movement along the curves.
• Claiming a certain quantity change when both curves shift. With a demand increase and a supply decrease, only the rate change is certain.
• Jumping to net exports. Unless the question asks, stop at the exchange rate. The effect on net exports and aggregate demand is Topic 6.5.

Where this leads

Next, in Topic 6.5, Changes in the Foreign Exchange Market and Net Exports, you will see how an appreciation or depreciation changes exports, imports, net exports and aggregate demand. Topic 6.6 then looks more closely at real interest rates and international flows of financial capital. Try the practice questions now, then use the revision notes and the checklist to consolidate.