US Central Bank Rate Cut
The question
Assume the foreign exchange market for the US dollar is initially in equilibrium. The US central bank cuts its policy interest rate, lowering the return on US bonds relative to comparable bonds in the fictional country of Estara, whose rates are unchanged. Foreign investors respond by buying fewer US bonds. Show the effect of this change in the foreign exchange market for the US dollar, holding all else constant. Show the effect on the Foreign Exchange Market (USD) graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
US Central Bank Rate Cut: the worked answer
On the Foreign Exchange Market (USD) graph, Demand for dollars (D$) shifts left.
Why Demand for dollars (D$) shifts left
The rate cut lowers the return on US bonds relative to Estaran bonds, making US bonds less attractive to foreign investors. Because foreigners must acquire dollars to buy US bonds, their reduced bond purchases lower the quantity of dollars demanded at every exchange rate, shifting the demand for dollars to the left. American purchases of foreign goods and assets are unchanged, so the supply of dollars stays put.
What happens to the equilibrium
The dollar depreciates and the equilibrium quantity of dollars traded decreases.
The mistake students make on this one
Students commonly shift the supply of dollars right, reasoning that an easing central bank increases the money supply so more dollars must reach the currency market. This graph tracks currency conversion, not the money supply; what actually changed is that foreign investors want fewer dollars, which is a leftward shift of demand for dollars.
On exam day
Chain the money market to the FX market on multi-part FRQs: a policy rate cut lowers the return on US assets, foreigners buy fewer of them, D$ shifts left, and the dollar depreciates.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Demand for dollars (D$) shifts left and every other curve on the Foreign Exchange Market (USD) graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
More Foreign Exchange Market (USD) scenarios
Last updated