Foreign Exchange Rates Review for AP Economics (page 2)

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By — McGraw-Hill Professional
Updated on Mar 4, 2011

Connection to Monetary Policy

A final variable that affects the price of one currency relative to another is a difference in relative interest rates between nations. When the Fed increases the money supply, the interest rates on American financial assets begin to fall. If the interest rate is relatively lower in the United States, people around the world see U.S. financial assets as less attractive places to put their money. Demand for the dollar falls, and the dollar depreciates relative to other foreign currencies. A depreciating dollar makes goods in the United States less expensive to foreign consumers, so American net exports increase, which shifts the AD to the right. Likewise, if the Fed decreases the money supply, American interest rates begin to rise and the dollar appreciates relative to foreign currencies. An appreciating dollar makes American goods more expensive to foreign consumers, decreasing American net exports, shifting AD to the left.

Be careful! When interest rates rise, we see a decrease in capital investments (machinery and other equipment) because it becomes more costly to borrow for those projects. But, when interest rates rise, we see an increase in financial investments (bonds) because income earned on those bonds is rising.

  • Pay attention to the relationship between relative interest rates and exchange rates because it has made an appearance on several recent AP Macroeconomics exams.
  • All else equal, demand for the U.S. dollar increases and the dollar appreciates relative to the euro if:

Review questions for this study guide can be found at:

International Trade Review Questions for AP Economics

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