International Trade ❮ 169
KEY IDEA
Connection to Monetary Policy
A final variable that affects the price of one currency relative to another is a difference in
relative interest rates between nations. When the Fed increases the money supply, the inter-
est rates on American financial assets begin to fall. If the interest rate is relatively lower in
the United States, people around the world see U.S. financial assets as less attractive places
to put their money. Demand for the dollar falls, and the dollar depreciates relative to other
foreign currencies. A depreciating dollar makes goods in the United States less expensive
to foreign consumers, so American net exports increase, which shifts the AD to the right.
Likewise, if the Fed decreases the money supply, American interest rates begin to rise
and the dollar appreciates relative to foreign currencies. An appreciating dollar makes
American goods more expensive to foreign consumers, decreasing American net exports,
shifting AD to the left.
Be careful! When interest rates rise, we see a decrease in capital investments (machinery
and other equipment) because it becomes more costly to borrow for those projects. But
when interest rates rise, we see an increase in financial investments (bonds) because income
earned on those bonds is rising.
Again:
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• If the Fed ↑ MS, ↓i%, ↓D$, Depreciates the $, ↑ U.S. Net Exports, ↑ AD.
• If the Fed ↓ MS, ↑i%, ↑D$, Appreciates the $, ↓ U.S. Net Exports, ↓ AD.
Pay attention to the relationship between relative interest rates and exchange rates because
it has made an appearance on several recent AP Macroeconomics exams.
All else equal, demand for the U.S. dollar increases and the dollar appreciates relative
to the euro if:
• European taste for American-made goods is stronger.
• European relative incomes are rising, increasing demand for U.S. goods.
• The U.S. relative price level is falling, making U.S. goods relatively less expensive.
• Speculators are betting on the dollar to rise in value.
• The U.S. relative interest rate is higher, making the United States a relatively more
attractive place for financial investments (i.e., bonds).
12.4 Trade Barriers
Main Topics: Tariffs, Quotas
The issue of free trade is hotly politicized. Proponents usually argue that free trade raises
the standard of living in both nations, and most economists agree. Detractors argue that free
trade, especially with nations that pay lower wages than those paid to domestic workers,
costs domestic jobs in higher-wage nations. The evidence shows that in some industries, job
losses have certainly occurred as free trade has become more prevalent. To protect domestic
jobs, nations can impose trade barriers. Tariffs and quotas are among the most common of
barriers. It should be noted that the topic of trade barriers does not fall neatly into a review
of macroeconomics or microeconomics. A policy like a tariff on imported solar panels has a
clear impact on the micro market for solar panels, but such a policy will also have an impact
on the macroeconomy. Just to be on the safe side, take a quick review of this section in
advance of your AP Macro exam.
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