Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- Foreign buyers pay in their own currency, so a change in the exchange rate changes what they pay even when producers keep their prices.
- When a currency appreciates, the country’s goods become dearer abroad and foreign goods become cheaper at home: exports fall, imports rise, net exports fall.
- When a currency depreciates, the country’s goods become cheaper abroad and foreign goods dearer at home: exports rise, imports fall, net exports rise.
- NX is a component of AD, and this change is not caused by the price level, so AD shifts.
- Short run: AD up → real output, employment and the price level rise. AD down → all three fall.
Key relationships
Exchange rate written as kestas per valda (KS per VD). Valdoria (valda) and Kestria (kesta) are the fictional countries used in the study guide.
| Relationship | Rule | Use it to |
|---|---|---|
| Home good priced abroad | price in KS = price in VD × (KS per VD) | find what foreign buyers pay |
| Foreign good priced at home | price in VD = price in KS ÷ (KS per VD) | find what home buyers pay |
| Net exports | NX = X − M | find the trade balance |
| AD | AD = C + I + G + NX | see that NX shifts AD |
| Spending multiplier | 1 ÷ (1 − MPC) | size the shift in AD from a change in NX |
The chain to write out
cause → currency demand or supply shifts → appreciation or depreciation → exports and imports change → NX changes → AD shifts → output, employment and price level change (short run)
Assumptions
- Other things equal: incomes, tastes and producers’ own prices do not change.
- The exchange rate is flexible and set by the foreign exchange market.
- You predict directions, not sizes of trade responses.
Mistakes to avoid
- “Stronger currency, more exports.” It is the opposite.
- Upside-down conversions. Multiply by KS per VD to go from VD to KS; divide to go back.
- Adding imports to AD. Imports are subtracted.
- Movement instead of shift. A currency change not caused by the price level shifts AD.
- Both countries gaining NX. If Valdoria’s NX with Kestria rise, Kestria’s fall.
- Stopping at NX when the question asks about output, unemployment or the price level.
Quick self-check
- A Valdorian good costs VD 80. What does it cost in Kestria at 1 VD = 6 KS, and at 1 VD = 5 KS? (KS 480, then KS 400)
- A Kestrian good costs KS 300. What does it cost in Valdoria at 1 VD = 6 KS, and at 1 VD = 5 KS? (VD 50, then VD 60)
- In questions 1 and 2, did the valda appreciate or depreciate, and what happens to Valdoria’s NX? (Depreciated; NX rise)
- Exports are VD 90 billion and imports VD 100 billion. What are net exports? (−VD 10 billion, a trade deficit)
Next: practice questions.