When the Fed raises interest rates, something happens eight thousand miles away: investors in Singapore and Frankfurt want dollars — U.S. bonds suddenly pay more. Their demand bids the dollar up; a stronger dollar makes American wheat pricier in Cairo and Japanese cars cheaper in Chicago; U.S. exports sag. One domestic policy decision, a planet-wide ripple. Unit 6 is where the course's threads — the real interest rate above all — cross the border. It's the smallest unit by weight, but its graph (FOREX) is among the most reliably asked, and its logic completes the model you've been building since Lesson 5.
Every international transaction lands in one of two accounts:
Accounting identity: CA + CFA = 0 (with statistical discrepancy ignored). A country running a current account deficit (importing more than it exports) must be running a financial account surplus (selling assets/borrowing from abroad) of equal size. Dollars foreigners earn selling us goods come back as purchases of our assets — the books always balance.
Sorting drill: a U.S. resident buys a Korean TV → CA (import). A Korean pension fund buys U.S. Treasury bonds → CFA (capital inflow). A U.S. firm receives dividends from its German subsidiary → CA (income).
The exchange rate is the price of one currency in another. Appreciation = currency strengthens (buys more foreign currency); depreciation = weakens. Rates are set in the foreign exchange market:
For the market for dollars (graph the currency being priced): - Demand for dollars (downward): foreigners needing dollars — to buy U.S. exports and U.S. assets. - Supply of dollars (upward): Americans supplying dollars — to buy imports and foreign assets.
Shifters (each has a mirror image on the other curve):
| Event | Effect |
|---|---|
| U.S. real interest rates rise relative to abroad | Foreign investors buy U.S. assets → demand for $ right → appreciation |
| Foreign incomes rise | More U.S. exports bought → demand for $ right → appreciation |
| U.S. incomes rise | Americans import more → supply of $ right → depreciation |
| U.S. inflation higher than abroad | U.S. goods pricier → export demand falls (D$ left) and imports rise (S$ right) → depreciation |
| Tastes favor U.S. goods | Demand for $ right → appreciation |
| Expected appreciation of the dollar | Speculative demand for $ right → appreciation |
The interest-rate channel is the exam's favorite — it's the real-interest-rate thread crossing the border: policy moves rates → capital flows chase returns → currency moves → net exports respond.
Now chain a full policy story: the Fed tightens → U.S. rates rise → capital inflows → dollar appreciates → Xn falls → AD shifts further left. The exchange-rate effect reinforces contractionary monetary policy. (Fiscal deficits do the opposite dance: deficits → r↑ → capital inflow → appreciation → Xn↓ — an international crowding out that piles onto Lesson 11's domestic version.)
Tariffs (taxes on imports) and quotas (quantity limits) raise domestic prices of protected goods, help protected producers, hurt consumers, invite retaliation, and shrink the gains from trade. They may narrow a trade deficit but at an efficiency cost — the Unit 6 policy-evaluation staple.
Apply It: The euro area booms while the U.S. economy is steady. For the dollar market: which curve, which way, and what happens to U.S. Xn? → European income growth raises purchases of U.S. exports → demand for dollars right → dollar appreciates. But the direct export boost dominates: Xn rises on net (the appreciation partially offsets it).
[GRAPH: FOREX — market for the U.S. dollar
X-axis: Quantity of dollars
Y-axis: Exchange rate (euros per dollar — the price of $1)
Curve 1: Demand for dollars, downward-sloping (foreigners buying U.S. exports/assets)
Curve 2: Supply of dollars, upward-sloping (Americans buying imports/foreign assets)
Equilibrium at (Q₁, e₁)
Shift: U.S. interest rates rise relative to Europe → foreign investors buy
U.S. bonds → demand for dollars shifts right → new equilibrium (Q₂, e₂ > e₁)
→ the dollar APPRECIATES → U.S. net exports fall]
AP labeling requirements: title the graph with WHICH currency's market it is; y-axis = the price of that currency in the other currency (e.g., "euros per dollar"); label both curves, both equilibria. Direction discipline: an event that increases demand for the graphed currency appreciates it. If the question narrates the other country's actions, translate into this market first (their imports of our goods = demand for our currency). One event often shifts both curves (e.g., inflation) — the exam usually keys the dominant single shift; state both if asked to explain fully.
1. E. Buying foreign goods = an import, recorded in the current account. A/B: no asset changed hands. C: an export runs the other way. D: transfers are gifts/remittances, not purchases.
Fix: Goods and services → current account; imports are the debit side.
2. C. Foreign purchase of U.S. assets = financial account inflow. A: bonds aren't goods or services. B: nothing was imported. D: not a gift. E: everything cross-border is recorded.
Fix: Asset transactions — stocks, bonds, property — live in the capital/financial account.
3. A. CA + CFA = 0: a $200B current deficit is financed by a $200B net capital inflow. B/C/E: violate the identity. D: the identity holds under any exchange regime.
Fix: The accounts are mirror images; a trade deficit means selling assets/borrowing abroad, dollar for dollar.
4. D. Appreciation = the currency buys MORE foreign currency. A/B: those forces cause depreciation. C: that's depreciation defined. E: trade balances respond to the rate, not the definition.
Fix: Appreciate = strengthen = more foreign currency per unit; depreciate = the reverse.
5. B. Foreigners need dollars for U.S. goods and assets — that's the demand side. A/D: Americans supply dollars when buying foreign things. C/E: the Fed and Treasury aren't the model's FOREX actors.
Fix: Demand for a currency comes from outsiders wanting that country's exports and assets.
6. D. Higher relative U.S. returns pull in foreign capital → more demand for dollars → appreciation. A/B: wrong curve/direction for capital inflows. C: rates drive FOREX through asset demand. E: unfounded.
Fix: Relatively higher real rates → capital inflow → currency appreciates. The thread crosses the border here.
7. A. A stronger dollar prices U.S. goods out and imports in: Xn falls. B: "stronger" harms exporters. C: no such definition. D: imports get cheaper. E: tariffs are a separate instrument.
Fix: Appreciation ↓Xn, depreciation ↑Xn — finish every FOREX chain with this line.
8. C. Higher U.S. incomes → more imports → Americans supply more dollars → depreciation pressure. A/D: that's what foreign income growth does. B: private trade doesn't wait for the Fed. E: unfounded.
Fix: Whose income rose? Theirs → demand for our currency; ours → supply of our currency.
9. E. Relatively expensive U.S. goods → foreigners buy fewer (D$ left), Americans import more (S$ right) → depreciation. A/C: high inflation doesn't strengthen a currency in this model. B: relative prices are exactly what FOREX trades on. D: nothing fixes the rate here.
Fix: Relatively high inflation → depreciation; the currency adjusts to restore competitiveness.
10. B. Lower relative rates push capital abroad → less demand for dollars (and more supply) → depreciation. A/C/D/E: each strengthens the dollar (inflows, export demand, asset purchases, self-fulfilling expectations).
Fix: Rate cuts weaken the currency; rate hikes strengthen it — relative to the world, always.
11. C. Cheaper currency → exports up, imports down → Xn up → AD right. A: backwards. B: imports get more expensive. D: depreciation typically narrows trade deficits. E: Xn is a component of AD.
Fix: Depreciation is expansionary through Xn — the open-economy stimulus channel.
12. D. Deficits → r↑ → foreign capital chases U.S. returns → dollar appreciates → Xn falls. This is international crowding out stacked on the domestic kind. A/B/C: describe the opposite flow. E: the financial account moves toward surplus; the current account weakens.
Fix: Fiscal deficits hit Xn twice-removed: r↑ → appreciation → Xn↓.
13. A. A tariff raises the import's domestic price: protected producers gain; consumers and downstream industries pay; efficiency and trade gains shrink. B/D: taxes on imports raise prices. C: barriers reduce gains from trade. E: foreign producers lose sales.
Fix: Tariffs redistribute from consumers (and users) to protected producers, with an efficiency loss on top.
The central bank of Ostania (currency: the crown) lowers its policy interest rate substantially. Interest rates in neighboring Weslandia (currency: the mark) are unchanged.
(a) Draw a correctly labeled graph of the foreign exchange market for the Ostanian crown, showing the initial equilibrium exchange rate e₁ (marks per crown).
(b) Show and explain the effect of Ostania's interest rate cut on your graph. Label the new exchange rate e₂. (Shift one curve.)
(c) State what happens to the international value of the crown.
(d) Explain the effect of the change in the crown's value on Ostania's net exports and aggregate demand.
1. E. Buying foreign goods = an import, recorded in the current account. A/B: no asset changed hands. C: an export runs the other way. D: transfers are gifts/remittances, not purchases. Fix: Goods and services → current account; imports are the debit side.
2. C. Foreign purchase of U.S. assets = financial account inflow. A: bonds aren't goods or services. B: nothing was imported. D: not a gift. E: everything cross-border is recorded. Fix: Asset transactions — stocks, bonds, property — live in the capital/financial account.
3. A. CA + CFA = 0: a $200B current deficit is financed by a $200B net capital inflow. B/C/E: violate the identity. D: the identity holds under any exchange regime. Fix: The accounts are mirror images; a trade deficit means selling assets/borrowing abroad, dollar for dollar.
4. D. Appreciation = the currency buys MORE foreign currency. A/B: those forces cause depreciation. C: that's depreciation defined. E: trade balances respond to the rate, not the definition. Fix: Appreciate = strengthen = more foreign currency per unit; depreciate = the reverse.
5. B. Foreigners need dollars for U.S. goods and assets — that's the demand side. A/D: Americans supply dollars when buying foreign things. C/E: the Fed and Treasury aren't the model's FOREX actors. Fix: Demand for a currency comes from outsiders wanting that country's exports and assets.
6. D. Higher relative U.S. returns pull in foreign capital → more demand for dollars → appreciation. A/B: wrong curve/direction for capital inflows. C: rates drive FOREX through asset demand. E: unfounded. Fix: Relatively higher real rates → capital inflow → currency appreciates. The thread crosses the border here.
7. A. A stronger dollar prices U.S. goods out and imports in: Xn falls. B: "stronger" harms exporters. C: no such definition. D: imports get cheaper. E: tariffs are a separate instrument. Fix: Appreciation ↓Xn, depreciation ↑Xn — finish every FOREX chain with this line.
8. C. Higher U.S. incomes → more imports → Americans supply more dollars → depreciation pressure. A/D: that's what foreign income growth does. B: private trade doesn't wait for the Fed. E: unfounded. Fix: Whose income rose? Theirs → demand for our currency; ours → supply of our currency.
9. E. Relatively expensive U.S. goods → foreigners buy fewer (D$ left), Americans import more (S$ right) → depreciation. A/C: high inflation doesn't strengthen a currency in this model. B: relative prices are exactly what FOREX trades on. D: nothing fixes the rate here. Fix: Relatively high inflation → depreciation; the currency adjusts to restore competitiveness.
10. B. Lower relative rates push capital abroad → less demand for dollars (and more supply) → depreciation. A/C/D/E: each strengthens the dollar (inflows, export demand, asset purchases, self-fulfilling expectations). Fix: Rate cuts weaken the currency; rate hikes strengthen it — relative to the world, always.
11. C. Cheaper currency → exports up, imports down → Xn up → AD right. A: backwards. B: imports get more expensive. D: depreciation typically narrows trade deficits. E: Xn is a component of AD. Fix: Depreciation is expansionary through Xn — the open-economy stimulus channel.
12. D. Deficits → r↑ → foreign capital chases U.S. returns → dollar appreciates → Xn falls. This is international crowding out stacked on the domestic kind. A/B/C: describe the opposite flow. E: the financial account moves toward surplus; the current account weakens. Fix: Fiscal deficits hit Xn twice-removed: r↑ → appreciation → Xn↓.
13. A. A tariff raises the import's domestic price: protected producers gain; consumers and downstream industries pay; efficiency and trade gains shrink. B/D: taxes on imports raise prices. C: barriers reduce gains from trade. E: foreign producers lose sales. Fix: Tariffs redistribute from consumers (and users) to protected producers, with an efficiency loss on top.
Exam tip: Every FOREX question is four decisions: (1) whose currency's market? (2) which curve — who wants that currency? (3) which way? (4) what happens to Xn and AD? Answer them in order, out loud if you must. And keep the master thread visible to the end: interest rates move capital, capital moves currencies, currencies move net exports, net exports move AD. That single chain — Lessons 10, 11, and 15 joined — is the highest-yield sentence in the whole course. Mock Exam 2 awaits: the full model, all six units.