6.5 - Changes in the Foreign Exchange Market and Net Exports
Currency Appreciation
A currency appreciates when its demand rises or its supply falls in the FOREX market. Say the exchange rate moves from 20 pesos per dollar to 40 pesos per dollar, that’s the dollar appreciating.
When a currency appreciates, imports get cheaper and exports get pricier for foreign buyers. For example, if a U.S. soda cost 60 pesos in Mexico, after this appreciation it now costs 120 pesos, while a Mexican soda that cost $2 in the U.S. now costs just $1.
Effects:
- Exports fall, imports rise, so net exports fall.
- Since is a component of AD, this shifts AD left, which lowers real output, employment, and the price level (unemployment rises).
- The current account balance falls, while the capital and financial account balance rises.
Currency Depreciation
If the rate instead drops (say from 40 pesos per dollar back to 20), the dollar depreciates.
Now imports get pricier and exports get cheaper for foreigners. The U.S. soda drops back to 60 pesos, and the Mexican soda rises back to $2.
Effects:
- Exports rise, imports fall, so net exports rise.
- This shifts AD right, raising real output, employment, and the price level (unemployment falls).
- The current account balance rises, while the capital and financial account balance falls.
Putting It Together
AP questions usually start with a cause and make you follow it all the way to AD. Example: real interest rates in Mexico rise.
- U.S. savers want Mexican bonds, so they supply dollars to buy pesos. The supply of dollars increases and the dollar depreciates (6.4, 6.6).
- U.S. goods get cheaper for Mexicans and Mexican goods get pricier for Americans, so U.S. exports rise, imports fall, and net exports rise.
- Net exports are part of AD, so U.S. AD shifts right. In the short run, real GDP, employment, and the price level all rise.
Bottom line: appreciation makes a country’s exports pricier, shrinking net exports and shifting AD left. Depreciation makes exports cheaper, growing net exports and shifting AD right.