Export Slump, Bonds Abroad
The question
Assume the foreign exchange market for the US dollar is initially in equilibrium. A deep recession in the fictional country of Norhavn causes Norhavnian households and firms to sharply cut their purchases of American-made goods. In the same period, the unrelated country of Selvenia lifts long-standing restrictions on foreign ownership of its government bonds, and US pension funds begin buying large volumes of Selvenian bonds. Show the effect of these two changes 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.
Export Slump, Bonds Abroad: the worked answer
On the Foreign Exchange Market (USD) graph, Demand for dollars (D$) shifts left and Supply of dollars (S$) shifts right.
Why Demand for dollars (D$) shifts left and Supply of dollars (S$) shifts right
Norhavnian buyers must obtain dollars before they can pay for American goods, so the recession that cuts their purchases lowers the quantity of dollars wanted at every exchange rate and the demand for dollars shifts left. US pension funds buying Selvenian bonds must first exchange dollars for Selvenian currency, so those purchases put more dollars up for sale at every exchange rate and the supply of dollars shifts right. Both shifts push the value of the dollar down, so the dollar definitely depreciates. The two shifts pull the quantity of dollars traded in opposite directions, so that quantity is indeterminate: it falls if the decrease in demand is larger, rises if the increase in supply is larger, and is unchanged if the two offset exactly.
What happens to the equilibrium
The dollar definitely depreciates, while the equilibrium quantity of dollars traded is indeterminate and depends on which of the two shifts is larger.
The mistake students make on this one
Students routinely report both outcomes as determinate, writing that the dollar depreciates and the quantity of dollars traded falls because a recession sounds like less of everything. The bond purchases push the quantity the other way, and with no information about the relative size of the two shifts the quantity traded cannot be signed at all. A second error is treating the pension funds as buyers of dollars, when buying a foreign bond requires selling dollars for foreign currency.
On exam day
Draw the case twice, once with each shift as the larger one, and if the equilibrium quantity lands on opposite sides of its original level in the two drawings, write that it is indeterminate and name what it depends on.
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$) shifts left and Supply of dollars (S$) shifts right 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.
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