US Incomes Rise: The Dollar Depreciates
Rising American incomes pull in more imports, Americans supply more dollars to pay for them, and the dollar depreciates.
US Incomes Rise: The Dollar Depreciates
Foreign Exchange Market (USD)Rising American incomes pull in more imports, Americans supply more dollars to pay for them, and the dollar depreciates.
Equilibrium at Quantity of USD 80, Exchange Rate (foreign / USD) 1
Start at Equilibrium
The dollar market opens in equilibrium where the demand for dollars (D$) equals the supply of dollars (S$). The exchange rate on the vertical axis is foreign currency per dollar.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
US Incomes Rise: The Dollar Depreciates, step by step
- 1
Start at Equilibrium
The dollar market opens in equilibrium where the demand for dollars (D$) equals the supply of dollars (S$). The exchange rate on the vertical axis is foreign currency per dollar.
- 2
Incomes Rise and Imports Boom
A strong US expansion raises household incomes, and because imports are normal goods Americans buy more of them at every exchange rate. Paying a foreign seller requires foreign currency, so Americans must supply more dollars to the foreign exchange market to get it. The supply of dollars shifts right. Foreign incomes have not changed, so the demand for dollars stays put.
- 3
The Dollar Depreciates
The new intersection sits at a lower exchange rate, so one dollar now buys less foreign currency and the dollar has depreciated. The equilibrium quantity of dollars traded rises as the market absorbs the larger supply.
- 4
Why Booms Weaken a Currency
Students often assume a strong economy means a strong currency. Through the income and import channel the opposite happens, because faster growth pulls in imports and every import is paid for by supplying dollars. An interest rate channel can push the other way, but that is a separate shock and is not what happened here.
Where it ends up
The supply of dollars shifts right, so the dollar depreciates while the quantity of dollars traded rises, showing that a booming economy can weaken its own currency through the import channel.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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