Recession at Home
The question
Assume the foreign exchange market for the US dollar is initially in equilibrium. A severe recession in the United States causes American household incomes to fall sharply, and American households buy far fewer imported goods. Assume foreign incomes and foreign purchases of US goods and 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.
Recession at Home: the worked answer
On the Foreign Exchange Market (USD) graph, Supply of dollars (S$) shifts left.
Why Supply of dollars (S$) shifts left
Americans must exchange dollars for foreign currency to pay for imported goods, so US import purchases are the source of the supply of dollars in this market. Lower household incomes mean Americans buy fewer imports, so fewer dollars are offered in exchange for foreign currency at every exchange rate and the supply of dollars shifts to the left. Foreign incomes and foreign purchases of US goods and assets are unchanged by assumption, so the demand for dollars stays put.
What happens to the equilibrium
The dollar appreciates and the equilibrium quantity of dollars traded decreases.
The mistake students make on this one
Students frequently shift the demand for dollars left, reasoning that a weak US economy makes the dollar less desirable. The stem holds foreign behavior constant, and a leftward demand shift would predict a depreciation, the opposite of what happens when Americans stop converting dollars into foreign currency.
On exam day
Domestic income drives S$ and foreign income drives D$. Read which country the recession is in before you decide which curve to touch, because the two cases push the exchange rate in opposite directions.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Supply of dollars (S$) 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
Last updated