6.3 The Foreign Exchange Market
The foreign exchange market sets a currency's equilibrium exchange rate where demand for the currency meets its supply.
Draw the market for ONE currency: quantity of dollars on the x-axis, the exchange rate (price of the dollar in the other currency, e.g. euros per dollar) on the y-axis. Demand for dollars comes from foreigners who need dollars to buy U.S. goods, services, and assets. Supply of dollars comes from Americans exchanging dollars to buy foreign goods, services, and assets.
Every transaction touches two markets at once: an American demanding euros is simultaneously supplying dollars. That is why the dollar market and the euro market mirror each other — demand rising in one is supply rising in the other.
Equilibrium is where the curves cross; shifts in either curve change the exchange rate. If demand for dollars rises, the dollar appreciates; if the supply of dollars rises, it depreciates. Label axes with the specific currencies — 'euros per dollar' — because generic labels lose FRQ points.
Key terms for 6.3
Drag the curves yourself — the fastest way to make 6.3 stick.
Shifting the DEMAND for dollars when Americans buy more imports. Americans supply dollars to obtain foreign currency — that shifts the dollar SUPPLY curve right, depreciating the dollar.
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