168 ❯ Step 4. Review the Knowledge You Need to Score High
Figure 12.8S$D$Quantity of dollarsEuro price
of a dollar0.5 euroQeS$0.4 euroTIPTIPTo summarize:
• When the price of a currency is rising, it is said to be appreciating, or “stronger.” More
dollars are needed to buy a euro.
• When the price of a currency is falling, it is said to be depreciating, or “weaker.” Fewer
euros are needed to buy a dollar.It is very important to label the axes correctly in a FRQ that asks you to draw the market
for a currency. If the market is for the dollar, the x-axis should be labeled “Quantity of
dollars.” The label on the y-axis depends on how the dollar is being priced. If we are
pricing dollars in terms of the number of euros it takes to purchase $1, then the correct
label is “Euros per dollar” or “Euro price of a dollar” or even “€/$.” You will not earn
a graphing point if you call it simply “Price,” “P,” or “$.”Changes in Exchange Rates
The preceding example illustrates that market forces and changing macroeconomic vari-
ables have an impact in the rate of exchange between the dollar and the euro. There are
several determinants that affect currency appreciation and depreciation.
Consumer Tastes. When domestic consumers build a stronger preference for foreign-
produced goods and services, the demand for those currencies increases and the dollar
depreciates. On the other hand, if foreign consumers increase their demand for U.S.-made
goods, the dollar appreciates.
Relative Incomes. When one nation’s macroeconomy is strong and incomes are rising, all
else equal, they increase their demand for all goods, including those produced abroad. So if
Europeans are enjoying economic growth and the United States is in a recession, the rela-
tive buying power of European citizens is growing. They increase their consumption of both
domestic and U.S.-made goods, increasing demand for the dollar and appreciating its value.
Relative Inflation. If one nation’s price level is rising faster than that of another nation,
consumers seek the goods that are relatively less expensive. If European inflation is higher
than inflation in the United States, U.S.-made goods are a relative bargain to German
consumers and the dollar appreciates. This is another good reason for the Fed to keep
inflationary pressure low.
Speculation. Because foreign currencies can be traded as assets, there are investors who
seek to profit from buying currency at a low rate and selling it at a higher rate. For example,
if it appears that future interest rates will fall in the United States relative to interest rates
in Japan, the yen is looking like a good investment. Speculators would then increase their
demand for Japanese assets, thus appreciating the yen and depreciating the dollar.“Don’t forget
to label your
axes.” —Timot,
AP Student