Changes in the Foreign Exchange Market and Net Exports: Study Guide (Macroeconomics 6.5)

Why the exchange rate matters for trade

Foreign buyers do not pay in your currency’s price. They pay in their own currency. The exchange rate turns one price into the other. So when the exchange rate changes, the price a foreign buyer sees changes too, even if the producer’s own price has not moved.

Quick recap of the terms you met in Topics 6.2 to 6.4:

• Exchange rate: the price of one currency in terms of another.
• Appreciation: a currency rises in value; one unit buys more of the other currency.
• Depreciation: a currency falls in value; one unit buys fewer units of the other currency.
• Net exports (NX): exports minus imports (X − M). NX is one of the four components of aggregate demand: AD = C + I + G + NX.

Topic 6.4 explained why a currency appreciates or depreciates (shifts in the demand for or supply of the currency). This topic follows the story one step further: what the new exchange rate does to trade, and through trade, to the whole economy.

Our fictional economies: Valdoria and Kestria

Valdoria is a fictional country whose currency is the valda (VD). It trades with Kestria, another fictional country, whose currency is the kesta (KS). On this page every exchange rate is written as kestas per valda: “1 VD = 3 KS” means one valda buys three kestas. All prices and figures are fictional.

With the rate written this way, two conversions do all the work:

• Valdorian good, price in Kestria: price in KS = price in VD × (KS per VD)
• Kestrian good, price in Valdoria: price in VD = price in KS ÷ (KS per VD)

A rise in the KS-per-VD number is an appreciation of the valda and, at the same moment, a depreciation of the kesta.

How an appreciation changes trade

Suppose the valda appreciates. Follow each side of trade.

1. Exports. Each Valdorian good now costs Kestrian buyers more kestas. Kestrians buy fewer Valdorian goods, so Valdoria’s exports fall.
2. Imports. Each Kestrian good now costs Valdorian buyers fewer valdas. Valdorians buy more Kestrian goods, so Valdoria’s imports rise.
3. Net exports. X falls and M rises, so NX = X − M falls.

A depreciation of the valda works the other way round: Valdorian goods become cheaper abroad, so exports rise; Kestrian goods become dearer in Valdoria, so imports fall; NX rises.

Change in Valdoria’s currency	Valdorian goods in Kestria	Kestrian goods in Valdoria	Exports	Imports	Net exports
Valda appreciates	dearer	cheaper	fall	rise	fall
Valda depreciates	cheaper	dearer	rise	fall	rise

Notice that both effects push net exports the same way. That is why the direction of the change in NX is certain, even though you cannot always say how big each part is.

From net exports to aggregate demand

Net exports are part of aggregate demand. A change in NX caused by the exchange rate is not caused by a change in Valdoria’s price level, so it shifts the AD curve (Topic 3.1).

• Appreciation → NX falls → AD shifts left. In the short run, real output falls, employment falls (unemployment rises) and the price level falls.
• Depreciation → NX rises → AD shifts right. In the short run, real output rises, employment rises (unemployment falls) and the price level rises.

Because NX is spending, the multiplier from Topic 3.2 applies: the AD curve shifts by more than the first change in NX.

The full chain, which you should be able to write out in an exam answer, is:

cause (Topic 6.4) → shift in the foreign exchange market → currency appreciates or depreciates → exports and imports change → NX changes → AD shifts → real output, employment and the price level change

Worked example 1: prices and net exports after an appreciation

Question. The exchange rate changes from 1 VD = 3 KS to 1 VD = 4 KS. A Valdorian rice cooker costs VD 120 and a Kestrian bicycle costs KS 900; neither producer changes its own price. (a) Which currency appreciated? (b) Find the price of each good in the buyer’s currency before and after. (c) Valdoria’s statistics office estimates that exports fall from VD 150 billion to VD 138 billion and imports rise from VD 140 billion to VD 152 billion. Find the change in net exports and state the effect on AD.

(a) One valda now buys 4 kestas instead of 3, so the valda appreciated (by (4 − 3) ÷ 3 × 100 = 33.33%). The kesta depreciated: one kesta used to buy 1 ÷ 3 = 0.3333 VD and now buys 1 ÷ 4 = 0.25 VD, a fall of 25%.

(b)

Good	Before (1 VD = 3 KS)	After (1 VD = 4 KS)	Change for the buyer
Rice cooker, sold in Kestria	120 × 3 = KS 360	120 × 4 = KS 480	33.33% dearer
Bicycle, sold in Valdoria	900 ÷ 3 = VD 300	900 ÷ 4 = VD 225	25% cheaper

(c) NX before = 150 − 140 = +VD 10 billion (a trade surplus). NX after = 138 − 152 = −VD 14 billion (a trade deficit). Change = −14 − 10 = −VD 24 billion. NX falls, so AD shifts left, by more than VD 24 billion once the multiplier works through.

Check. The producers’ own prices did not change at all. The whole change in what buyers pay comes from the exchange rate. Also, the percentage changes are not equal (33.33% and 25%) because each is measured from a different starting value.

Worked example 2: a depreciation in a recession

Question. Valdoria is in a recession: real GDP is VD 940 billion and full-employment output is VD 1,000 billion. Valdorian savers decide to buy more Kestrian bonds, and the exchange rate falls from 1 VD = 4 KS to 1 VD = 3.5 KS. (a) Explain the cause of the change in the foreign exchange market. (b) Explain the effect on Valdoria’s net exports, using one exported and one imported good. (c) Net exports rise by VD 6 billion and the marginal propensity to consume (MPC) is 0.8. By how much does the AD curve shift? (d) State the short-run effects on real GDP, unemployment and the price level.

(a) To buy Kestrian bonds, Valdorian savers must sell valdas for kestas. The supply of valdas rises (shifts right), so the valda depreciates from 4 KS to 3.5 KS, a fall of (3.5 − 4) ÷ 4 × 100 = 12.5%.

(b) A kilogram of Valdorian tea at VD 50 used to cost Kestrians 50 × 4 = KS 200; it now costs 50 × 3.5 = KS 175, so Kestrians buy more and Valdoria’s exports rise. A Kestrian phone at KS 1,400 used to cost Valdorians 1,400 ÷ 4 = VD 350; it now costs 1,400 ÷ 3.5 = VD 400, so Valdorians buy fewer and imports fall. With X up and M down, NX rises.

(c) Spending multiplier = 1 ÷ (1 − MPC) = 1 ÷ 0.2 = 5. AD shifts right by 6 × 5 = VD 30 billion at each price level.

(d) AD shifts right along the upward-sloping SRAS curve. In the short run real GDP rises (towards VD 1,000 billion), unemployment falls and the price level rises. Real GDP rises by less than VD 30 billion, because part of the shift goes into a higher price level.

Interpretation. Here the depreciation helps: it narrows a VD 60 billion recessionary gap. The same depreciation in an economy already at full employment would mainly add to inflation.

Check. The kesta appreciated by 14.29% (from 1 ÷ 4 = VD 0.25 to 1 ÷ 3.5 = VD 0.2857), not 12.5%. One currency’s depreciation is always the other currency’s appreciation, but the two percentages differ.

How far the course takes this

• Direction, not size. You must predict the direction of the changes in exports, imports, NX, AD, output, employment and the price level. You are not asked to predict how much trade volumes respond to a given exchange-rate change.
• Other things equal. Answer from the exchange-rate change alone, holding incomes, tastes and producers’ own prices constant, as in the worked examples.
• Short run. The course links this topic to the short-run AD–AS effects. If a question asks about the long run, use Topic 3.7: output returns to full employment and only the price level stays changed.
• Background only. In real economies, trade often reacts to a currency change with a delay, because orders and contracts are agreed months ahead. This timing is not part of the course.

Two quick practice prompts to test yourself: if the kesta appreciates against the valda, what happens to Kestria’s net exports? (They fall.) What happens to Valdoria’s AD? (Valdoria’s NX rise, so its AD shifts right.)

Common misconceptions

• “An appreciation raises exports because the currency is stronger.” A stronger currency makes your goods dearer for foreigners, so exports fall.
• Getting the conversion upside down. With the rate in KS per VD, multiply to turn VD into KS and divide to turn KS into VD. Ask: should the answer be a bigger or smaller number?
• “Imports rise, so AD rises.” Imports are subtracted in AD = C + I + G + NX. Higher imports lower NX and AD.
• Saying both countries’ net exports rise. If the valda appreciates, the kesta depreciates: Valdoria’s NX with Kestria fall while Kestria’s NX with Valdoria rise.
• Treating the change as a movement along AD. The exchange rate effect explains why AD slopes downward when the price level changes. A currency change caused by something else (interest rates, investor demand, tariffs) shifts AD.
• Stopping the chain early. An exam answer that says “the currency appreciates, so NX fall” without explaining that exports become dearer and imports cheaper often loses the explanation point.
• Forgetting the short-run effects. If asked about output, employment or the price level, carry the chain through AD to all three.

Where this leads

Next, Topic 6.6 shows why differences in real interest rates between countries move financial capital, change exchange rates and so feed into net exports through the chain on this page: see the Topic 6.6 study guide. First try the practice questions, then use the revision notes and the checklist to consolidate. To review why a currency changes value, go back to Topic 6.4.