Retreat From Foreign Bonds
The question
Assume the foreign exchange market for the US dollar is initially in equilibrium. Political turmoil across several fictional emerging economies makes their government bonds look far riskier, and US pension funds call off the purchases of those bonds they had planned for this year, placing the money in US Treasury bonds instead. The funds keep the emerging-market bonds they already own rather than selling them. Assume trade in goods and services and foreigners' purchases of US assets are unchanged. Show the effect 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.
Retreat From Foreign Bonds: the worked answer
On the Foreign Exchange Market (USD) graph, Supply of dollars (S$) shifts left.
Why Supply of dollars (S$) shifts left
A US pension fund buying a foreign bond must first exchange dollars for the issuing country's currency, so American purchases of foreign assets are part of the supply of dollars in this market. When the funds call off those planned purchases and buy US Treasury bonds instead, a transaction that required no currency conversion, fewer dollars are offered in exchange for foreign currency at every exchange rate and the supply of dollars shifts to the left. Because the funds hold rather than sell the emerging-market bonds they already own, no foreign currency is converted back into dollars, and the prompt holds trade flows and foreign purchases of US assets constant, so the demand for dollars does not move.
What happens to the equilibrium
The dollar appreciates and the equilibrium quantity of dollars traded decreases.
The mistake students make on this one
Because flight-to-safety stories usually end with foreigners piling into US assets, many students shift the demand for dollars right. Every actor described here is American, and Americans deciding not to convert dollars into foreign currency shows up as a decrease in the supply of dollars, not an increase in demand.
On exam day
Underline the nationality of the buyer in the stem. Americans buying anything foreign, a good or a financial asset, always operate on the S$ side of this graph.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Supply of dollars (S$) 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
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