Foreign Exchange Market (USD) drawing worksheet

Foreign Exchange Market (USD) drawing worksheet: answer key

1. 1. Interest Rate Differential: demand shifts right

   Higher relative US interest rates make US bonds more attractive to British investors. To buy US bonds, those investors must first exchange pounds for dollars, which raises the quantity of dollars demanded at every exchange rate. Because the buyers are foreigners acquiring dollars, this is a change in the demand for dollars, and it shifts right. The supply of dollars, which comes from Americans buying foreign goods and assets, is unaffected here.

   The dollar appreciates and the equilibrium quantity of dollars traded increases.

   Watch for: A frequent wrong answer is shifting the supply of dollars left, on the idea that capital flowing into the United States pulls dollars out of circulation. British investors are not selling dollars, they are buying them, so the only side of this market that changes is the foreign side that must acquire dollars first.

2. 2. Appetite for Imports: supply shifts right

   To pay for Korean electronics, US households must exchange dollars for South Korean won. Americans exchanging dollars for foreign currency are the source of the supply of dollars in this market, so the increase in import buying raises the quantity of dollars supplied at every exchange rate and shifts supply right. Foreigners' willingness to acquire dollars has not changed, so the demand for dollars stays put.

   The dollar depreciates and the equilibrium quantity of dollars traded increases.

   Watch for: Students often shift the demand for dollars right because Americans are described as demanding more of something. What Americans demand here is Korean goods, which forces them to demand won and supply dollars; the D$ curve tracks foreigners wanting dollars, not Americans wanting products.

3. 3. Recession Abroad: demand shifts left

   Canadian buyers must exchange Canadian dollars for US dollars in order to purchase US-made goods. When the recession cuts those purchases, foreigners need fewer dollars at every exchange rate, so the demand for dollars shifts left. American spending on foreign goods and assets is unchanged, so the supply of dollars does not move.

   The dollar depreciates and the equilibrium quantity of dollars traded decreases.

   Watch for: The most common wrong answer is shifting the supply of dollars left, on the reasoning that fewer US exports means fewer dollars changing hands. US exports are paid for by foreigners who must buy dollars first, so a drop in exports is a decrease in the demand for dollars; S$ tracks Americans selling dollars, and nothing here changed what Americans buy abroad.

4. 4. Tourism Boom to the US: demand shifts right

   To pay for US hotels, meals, and tickets, Marovian visitors must first exchange their own currency for US dollars. Foreigners acquiring dollars are the source of the demand for dollars in this market, so their extra spending raises the quantity of dollars demanded at every exchange rate and shifts the demand for dollars to the right. American spending on foreign goods and assets is unchanged, so the supply of dollars stays put.

   The dollar appreciates and the equilibrium quantity of dollars traded increases.

   Watch for: Many students shift the supply of dollars because the visitors are described as spending money inside the United States. Those visitors have to buy dollars with Marovian currency before they can spend anything, and anyone acquiring dollars belongs on the demand side of this graph.

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