6.4 Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market
Relative interest rates, income, inflation, and tastes shift currency supply and demand: relatively higher interest rates appreciate a currency.
Four shifters drive the FOREX graph, and each works through RELATIVE comparisons between countries. Relative interest rates: if U.S. rates rise relative to others, foreign investors demand dollars to buy U.S. assets — the dollar appreciates. Relative income: if U.S. income grows faster, Americans import more, supplying dollars — the dollar depreciates.
Relative inflation: higher U.S. inflation makes U.S. goods less competitive, cutting foreign demand for dollars — depreciation. Tastes and expectations: stronger preference for a country's goods or expected currency gains raise demand for it — appreciation.
Policy chains tie back to earlier units: expansionary monetary policy lowers U.S. interest rates, reducing foreign demand for U.S. assets, so the dollar depreciates. Expansionary fiscal policy raises real interest rates (crowding out), attracting inflows and appreciating the dollar. Trace each chain link by link on FRQs.
Key terms for 6.4
Drag the curves yourself — the fastest way to make 6.4 stick.
Forgetting everything is RELATIVE. A rate hike abroad with U.S. rates unchanged still depreciates the dollar — what matters is the interest-rate differential, not the U.S. level alone.
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