The Most-Tested Graph in Unit 6
Section 6.2 gave you the vocabulary and intuition for exchange rates — what they are, what appreciation and depreciation mean, what they do to trade. Section 6.3 takes the next step: it builds the supply-and-demand model of the foreign exchange market, the graph that determines what the exchange rate actually is and how it changes over time. If you've graphed AD-AS, the money market, or the loanable funds market, you already know the moves — same axes, same logic of shifts, same equilibrium. The FOREX market just uses different variables.
Here's why this section is the single most important in Unit 6: the AP exam features a FOREX graph on essentially every recent test. FRQs ask you to "draw a correctly labeled graph of the foreign exchange market for the [country]'s currency" and show how some policy or event shifts demand or supply, then ask you to explain the consequence for net exports and AD. Multiple-choice questions show you a FOREX graph and ask which direction a curve shifts, or which event causes a shortage at a given price. Every single one of these is built from the same template you're about to learn.
By the end of this section, you should be able to:
- Draw the FOREX graph for any currency, label its axes correctly, identify equilibrium, and show shifts.
- Explain who demands and who supplies a country's currency, and why each curve has the slope it does.
- Predict the effect of any shock — interest rate changes, inflation differentials, income changes, preference shifts, speculation — on demand and supply.
- Understand the "mirror market" principle: when the dollar appreciates against the yen, the yen depreciates against the dollar, and both events can be shown on either graph.
📝 The FRQ pattern you're being prepared for: "Using a correctly labeled graph of the foreign exchange market for the Canadian dollar (expressed as Mexican pesos per Canadian dollar), show the effect of an increase in the Canadian real interest rate on the international value of the Canadian dollar." This kind of dual-step FRQ — draw the graph, show the shift, label the appreciation — is worth multiple rubric points. Drawing this from memory has to be automatic by exam day.
What Is Being Traded?
Before drawing any graph, get the mental model right. The foreign exchange market — usually just called "FOREX" or "the FX market" — is the market where one currency is bought and sold for another. It's not a physical place like the New York Stock Exchange; it's a worldwide network of banks, brokers, and electronic platforms where trillions of dollars worth of currency change hands every single day. But it's still a market, and like every market, it has buyers, sellers, and a price.
The Foreign Exchange Market: The global market in which currencies are bought and sold for one another. The "price" in this market is the exchange rate — how many units of one currency you give up to obtain one unit of another. Like any market, the equilibrium price and quantity are set by the intersection of supply and demand.
A Key Modeling Decision
Here's the twist that makes the FOREX market different from every other supply-and-demand graph you've drawn. In the market for, say, hamburgers, there's only one hamburger market — buyers want hamburgers, sellers sell hamburgers, and the price tells you how many dollars per hamburger. Simple.
In the FOREX market, every transaction involves two currencies. If you're a Japanese tourist buying dollars, you're simultaneously supplying yen and demanding dollars. The same trade can be drawn on a graph for either currency. So when AP exam questions say "the market for U.S. dollars in terms of yen," they mean: draw the graph with the dollar's price on the y-axis (yen per dollar) and the quantity of dollars on the x-axis. There's a separate "market for yen in terms of dollars" with dollar/yen on the y-axis and yen on the x-axis. They're mirror images of each other.
For most AP questions, you'll be drawing the market for one specific currency at a time. Pick which currency the question asks about, and stick with that perspective throughout. The other currency is the "implied" mirror of your graph, but you don't usually need to draw it.
🎯 First habit to lock in: When you see a FOREX question, your first task is to identify which currency's market the question is asking about. The graph is for that currency, and that currency's price (in foreign-currency units) goes on the y-axis, that currency's quantity goes on the x-axis. Everything else follows from that choice.
Reading the FOREX Graph: Anatomy
Let's draw a baseline FOREX graph and walk through each piece. We'll use the U.S. dollar market expressed in Japanese yen — a common AP exam setup.
The Y-Axis: Price of the Currency
The y-axis is the exchange rate — but expressed very precisely. It's the price of the currency on the x-axis, denominated in the foreign currency. For the dollar market expressed in yen, the y-axis is "yen per dollar." When this number rises, the dollar has gotten more expensive (in yen) — the dollar has appreciated. When the number falls, the dollar has depreciated. Moving up the y-axis = appreciation. Moving down the y-axis = depreciation. Lock that in.
The X-Axis: Quantity of the Currency
The x-axis is the quantity of the currency traded on the FOREX market. The higher the volume of trading in dollars (people buying or selling dollars for yen), the further right we are on the x-axis. The "quantity" here isn't the money supply (that was Unit 4); it's just how much of the currency is changing hands in international transactions.
Why Demand Slopes Downward
The demand curve for dollars slopes down for the same reason any demand curve slopes down: when the price is higher, fewer people want to buy. Think of who demands dollars. If a Japanese tourist wants to visit Disney World, she needs dollars. If the dollar is expensive (¥150 per $1), her trip is expensive in yen, so she might cancel or shorten the trip — demanding fewer dollars. If the dollar is cheap (¥100 per $1), her trip is cheaper in yen, so she takes a longer trip and buys more — demanding more dollars. Higher dollar price → fewer dollars demanded. Standard downward-sloping demand.
Why Supply Slopes Upward
Supply of dollars comes from Americans selling dollars to obtain foreign currency. If you're an American who wants to vacation in Japan, you supply dollars (selling them) to get yen. When the dollar is expensive in yen terms (¥150 per $1), each dollar you sell gets you a lot of yen — Japan looks cheap, and you supply more dollars to make the trip. When the dollar is cheap in yen terms (¥100 per $1), Japan looks expensive in dollar terms, so fewer Americans travel there — fewer dollars supplied. Higher dollar price → more dollars supplied. Standard upward-sloping supply.
Who's on Each Side of the Dollar Market?
Demand for dollars (D$) comes from foreigners who want dollars — to buy U.S. exports, invest in U.S. assets, travel to the U.S., or hold dollar reserves. As the dollar gets more expensive in their currency, they demand fewer.
Supply of dollars (S$) comes from Americans who are selling dollars to get foreign currency — to buy imports, invest abroad, travel overseas. As the dollar gets stronger in foreign-currency terms, foreign things look cheap, so Americans supply more dollars to buy them.
If you flipped the market to be "the yen market," the roles reverse: Japanese supply yen (to obtain dollars for their own imports/travel/investments abroad); foreigners demand yen (to buy Japanese exports, invest in Japan, travel there).
What Shifts Demand and Supply?
Movement along the curves happens because the exchange rate changes. But the curves themselves can shift when the underlying conditions of demand and supply change. Shifts of D$ and S$ are caused by changes in the four big factors we previewed in 6.2 — interest rates, income, inflation, and preferences/expectations. Each one operates through a specific channel.
Demand Shifters (Who Wants Dollars, and Why?)
Demand for dollars comes from foreigners. The demand curve shifts right (more dollars demanded at every price) when foreigners want more dollars. It shifts left when they want fewer. Here are the main triggers:
| Trigger | Effect on D$ | Why it happens |
|---|---|---|
| U.S. interest rates rise relative to foreign rates | D$ shifts RIGHT → $ appreciates | Higher U.S. returns attract foreign investors. To buy U.S. bonds, they must first acquire dollars → demand for $ increases. |
| Foreign demand for U.S. exports increases | D$ shifts RIGHT → $ appreciates | To buy U.S. goods (Boeing planes, U.S. semiconductors, Hollywood films), foreigners need dollars. More export demand = more demand for $. |
| Foreign income/GDP rises | D$ shifts RIGHT → $ appreciates | Richer foreigners can afford more U.S. goods and more U.S. travel → more demand for $. |
| Foreign inflation rises relative to U.S. inflation | D$ shifts RIGHT → $ appreciates | U.S. goods become relatively cheaper than foreign goods → foreigners buy more U.S. exports → more demand for $. |
| U.S. inflation rises relative to foreign inflation | D$ shifts LEFT → $ depreciates | U.S. goods become more expensive abroad → foreigners buy fewer U.S. exports → less demand for $. |
| Foreigners expect the dollar to weaken | D$ shifts LEFT → $ depreciates | If foreigners expect the dollar to drop, they don't want to hold dollars now → demand falls (often self-fulfilling). |
Supply Shifters (Why Are Americans Selling Dollars?)
Supply of dollars comes from Americans wanting to sell dollars to get foreign currency. The supply curve shifts right (more dollars supplied at every price) when Americans want more foreign currency. It shifts left when they want less.
| Trigger | Effect on S$ | Why it happens |
|---|---|---|
| U.S. interest rates fall relative to foreign rates | S$ shifts RIGHT → $ depreciates | U.S. assets look less attractive; Americans invest abroad to get higher returns. To do so they must sell dollars → supply of $ rises. |
| U.S. income/GDP rises | S$ shifts RIGHT → $ depreciates | Richer Americans buy more imports → must sell more dollars to get foreign currencies → supply of $ rises. |
| U.S. inflation rises relative to foreign inflation | S$ shifts RIGHT → $ depreciates | U.S. goods become relatively expensive → Americans buy more imports → sell more dollars on FOREX. (Note: this is the supply-side mirror of the demand effect from inflation — both curves move, both pushing the dollar down.) |
| Americans develop a stronger preference for foreign goods | S$ shifts RIGHT → $ depreciates | If Americans suddenly want more Japanese cars or French wine, they sell more dollars to buy those goods → supply of $ rises. This is the iPhone-vs-Toyota example from the AP exam. |
| Americans expect the dollar to weaken | S$ shifts RIGHT → $ depreciates | Americans rush to convert dollars to foreign assets before the dollar drops further → supply rises now → self-fulfilling depreciation. |
| U.S. interest rates rise relative to foreign rates | S$ shifts LEFT → $ appreciates | Americans invest less abroad (better returns at home) → fewer dollars sold to obtain foreign currency → S$ falls. (This complements the D$ effect — both curves help appreciate the dollar.) |
An Important Pattern: Many Shocks Hit Both Curves
Look at the two tables side by side. Several shocks (interest rate changes, inflation differentials) appear in both — they shift demand and supply in the same direction (with respect to the currency's value). For AP exam purposes, this is a feature, not a bug. The two effects reinforce each other and make the direction of the price change unambiguous, even though the effect on quantity traded is theoretically ambiguous (because demand and supply moving the same way push quantity in opposite directions).
For the AP exam, when explaining one of these shocks, you can show either a demand shift, or a supply shift, or both. The rubric typically accepts any of these as long as you correctly identify the direction of the exchange-rate movement. Drawing both is more complete but not always required.
⚠️ A common AP exam point of confusion: Many students freeze when they realize a shock affects both curves. Don't. Pick the channel that's most direct for the question being asked, draw the corresponding shift, and explain why. Example: "U.S. interest rates rise" — for an FRQ, show D$ shifting right (because of foreign capital inflow) and label the appreciation. If the rubric wanted S$ shifting left, your answer is still typically accepted because the resulting appreciation is the same.
Worked Examples: Shifting the FOREX Graph
Let's work through the two most common AP exam scenarios with the corresponding graphs. Each one follows the same recipe: identify the shock, identify the channel (D or S), shift the correct curve, label the new equilibrium, and read off the exchange-rate change.
Scenario 1: U.S. Interest Rates Rise (Demand Shift)
The Fed raises interest rates (or U.S. rates rise for any reason)
U.S. Treasury bonds now offer higher yields than foreign bonds. American assets become more attractive to global investors.
Foreign capital seeks U.S. assets
Japanese pension funds, European banks, and Saudi sovereign wealth funds all want to buy more U.S. bonds. To do so, each one must first convert its currency into dollars.
Demand for dollars shifts right (D$₀ → D$₁)
At every exchange rate, the quantity of dollars demanded is higher than before. This is shown by an outward shift of the demand curve.
The dollar appreciates from e₀ to e₁
The new equilibrium is at a higher price (more yen per dollar). The quantity of dollars traded also rises.
Scenario 2: Americans Develop a Preference for Foreign Goods (Supply Shift)
U.S. consumers shift preferences toward foreign goods
Suppose Americans suddenly want more Japanese cars (this is literally the AP 2018 exam scenario). Demand for imports rises.
To buy foreign goods, Americans need foreign currency
A Toyota dealership in California needs to pay Toyota in yen. To get yen, Americans (or the U.S.-based dealership) must sell dollars on the FOREX market.
Supply of dollars shifts right (S$₀ → S$₁)
At every exchange rate, more dollars are being sold to obtain yen. The supply curve shifts outward.
The dollar depreciates from e₀ to e₁
With more dollars chasing the same demand, the dollar's price (in yen) falls. The dollar has depreciated against the yen. Quantity of dollars traded rises.
🎯 The recipe for any FRQ FOREX question: (1) Draw the standard graph with the right axes for the currency in question. (2) Identify the shock and the channel — does it affect demand (foreigners' behavior) or supply (Americans' behavior)? (3) Shift the correct curve in the correct direction. (4) Label the new equilibrium with a new price (e₁) and a new quantity (Q₁). (5) Read off whether the currency appreciated or depreciated. Each of these is typically a separate rubric point.
Surplus, Shortage, and the Wrong-Price Question
The AP exam sometimes tests a slightly different question: instead of asking what shifts a curve, it shows you a FOREX graph and tells you the exchange rate is being held at a specific (non-equilibrium) value. Then it asks: is there a surplus or shortage at this price, and which way will the rate move under a flexible system? This is the same logic as in any market.
Shortage → Currency will Appreciate
If the dollar is artificially cheap (below the equilibrium ¥/$), foreigners want to buy lots of dollars (high Qd), but Americans don't want to sell many (low Qs). Quantity demanded exceeds quantity supplied — there's a shortage of dollars at this price. Under a flexible system, the dollar's price rises (it appreciates) until equilibrium is restored.
Example: Equilibrium is ¥7/$, but the current rate is ¥6/$. The dollar is "too cheap" — there's a shortage. Without government intervention, the dollar's price rises toward ¥7/$.
Surplus → Currency will Depreciate
If the dollar is artificially expensive (above the equilibrium ¥/$), Americans rush to sell dollars (high Qs), but foreigners don't want to buy many at this price (low Qd). Quantity supplied exceeds quantity demanded — there's a surplus of dollars at this price. Under a flexible system, the dollar's price falls (it depreciates) until equilibrium is restored.
Example: Equilibrium is ¥7/$, but the current rate is ¥8/$. The dollar is "too expensive" — there's a surplus. Without intervention, the dollar's price drifts down toward ¥7/$.
The Yuan-Dollar Question
Scenario: An AP exam shows the dollar-yuan FOREX market. The equilibrium exchange rate is ¥7 per dollar, but the current rate is ¥6 per dollar. Under a flexible exchange-rate system, which of the following describes the current state of the market?
Step 1 — Compare to equilibrium: ¥6/$ is below the equilibrium ¥7/$. The dollar is priced "too low."
Step 2 — Identify shortage or surplus: At ¥6/$, lots of foreigners want to buy cheap dollars (high quantity demanded), but few Americans want to sell dollars at this low price (low quantity supplied). This is a shortage of dollars.
Step 3 — Direction of movement: A shortage means upward pressure on price. Under a flexible system, the dollar's price will rise (more ¥ per $) until reaching equilibrium at ¥7/$. The dollar appreciates.
⚠️ Don't confuse "shortage of dollars" with "shortage of dollars in the U.S." The shortage in the FOREX market is at a specific (non-equilibrium) exchange rate. It just means more dollars are being demanded than supplied at that price. It doesn't mean Americans don't have enough dollars — it means foreigners can't buy as many dollars as they want at the (too-cheap) price. Big difference.
The Mirror Market: One Event, Two Graphs
Recall from 6.2 the mirror rule: if the dollar appreciates against the yen, the yen depreciates against the dollar. These are the same event told from two perspectives. The same idea applies to FOREX graphs. Every shift you can draw in the dollar market has a corresponding shift in the yen market — they're not independent events; they're two views of the same event.
A Concrete Example: U.S. Interest Rates Rise
Suppose U.S. interest rates rise. In the dollar market, we just saw that D$ shifts right and the dollar appreciates. What's happening in the yen market at the same time?
Dollar Market: D$ shifts right
Demand for dollars shifts right. Equilibrium price (¥ per $) rises — dollar appreciates.
Yen Market: S¥ shifts right
Supply of yen shifts right (Japanese sell yen to buy dollars). Equilibrium price ($ per ¥) falls — yen depreciates.
The two graphs show the same event from opposite perspectives. From the dollar's side, demand for dollars rises (foreigners want dollars), pushing the dollar's price up — dollar appreciates. From the yen's side, supply of yen rises (Japanese sell yen to obtain dollars), pushing the yen's price down — yen depreciates. Same event, both perspectives, perfectly consistent.
The Translation Between Markets
If something causes demand for currency A to shift right in A's market, then in B's market it appears as the supply of currency B shifting right (because the very same foreign holders of B are selling B to obtain A).
If something causes supply of currency A to shift right in A's market, then in B's market it appears as the demand for currency B shifting right (because the very same domestic holders of A are demanding B to buy B's country's goods or assets).
This pairing — D shift in one market = S shift in the other — is why every event has two FOREX graphs but only one economic story.
🎯 Practical rule: On the AP exam, the FRQ tells you which currency's market to draw. Just draw that one. Don't draw both unless asked. The mirror market is a useful concept for understanding, but the FRQ rubric will award points only for the requested graph.
Common Misconceptions
The FOREX market combines two challenges: getting the axes right, and getting the shifters right. Each error below has appeared as a wrong-answer choice on real AP exams.
- "The y-axis of a FOREX graph is the value of the currency." Imprecise. The y-axis is the price of the currency expressed in the foreign currency. For the dollar market in yen, it's "¥ per $." Calling it "the value of the dollar" is informal — fine for intuition, but not precise. The unit matters, especially when an exam asks you to label your axes.
- "Higher interest rates shift the demand for the currency to the left." Backwards. Higher rates attract foreign investors, who demand more of the currency to buy domestic assets. Demand shifts right. Always trace through: who wants the currency, and why?
- "A change in the exchange rate causes the demand curve to shift." No. A change in the exchange rate is a movement along the demand curve, not a shift. Shifts of the demand curve are caused by changes in the underlying factors — interest rates, income, inflation, preferences, expectations — not by the price itself.
- "Supply of dollars comes from foreigners." Backwards. Supply of dollars comes from Americans (or U.S.-based actors) who are selling dollars to obtain foreign currency. Demand for dollars comes from foreigners. Mixing these up is the most common source of FOREX errors.
- "When U.S. inflation rises, only the supply of dollars shifts." Both curves shift, actually. Higher U.S. inflation makes U.S. goods more expensive: foreigners buy fewer (D$ shifts left), and Americans buy more imports (S$ shifts right). Both effects depreciate the dollar. For an FRQ, showing either shift is typically sufficient.
- "The FOREX market only matters when there's trade." Misses half of FOREX. The FOREX market is just as much about asset purchases (foreign direct investment, portfolio investment, central bank reserves) as it is about goods and services trade. In fact, asset flows dwarf trade flows in volume.
- "At equilibrium, the country has a balanced current account." Wrong. FOREX equilibrium means quantity demanded equals quantity supplied of the currency, but those quantities reflect all reasons people want or sell the currency — including capital flows. The U.S. dollar is at FOREX equilibrium nearly every day, yet the U.S. has run a current account deficit for decades, because capital inflows balance the trade deficit. FOREX equilibrium ≠ Current Account = 0.
- "A shortage of dollars means there isn't enough money in the U.S." No. A shortage in the FOREX market means quantity demanded exceeds quantity supplied at a non-equilibrium price. It has nothing to do with the U.S. money supply.
- "Demand and supply for dollars are independent of each other." They share many drivers. Higher U.S. interest rates raise D$ (foreigners want dollars) and lower S$ (Americans hold onto dollars to earn the higher rate). Both effects appreciate the dollar. Treating them as fully independent misses these reinforcing dynamics.
- "Drawing both the dollar market and the yen market is required." Almost never. Most AP questions tell you which market to draw. Drawing both is more work and can confuse the grader. Draw only what the question asks for, and label it carefully.
⚡ 6.3 Quiz: 5 Questions
Click an answer to lock it in. Every option gets a full breakdown — what's right, what's wrong, and the AP-favorite trap each distractor is designed to catch.
1. The graph above (standard FOREX market for U.S. dollars in terms of Japanese yen) shows the foreign exchange market for U.S. dollars. Assume that there is an increase in U.S. consumers' preference for Japanese automobiles. Which of the following changes will most likely take place in the market for dollars?
✓ Correct answer: (C)
Trace the channel carefully. Americans want more Japanese cars. To buy Japanese cars, Americans need yen. To get yen, Americans (or U.S.-based dealerships) sell dollars on the FOREX market. Selling dollars means supplying dollars. So the supply of dollars shifts right. The end result is a lower exchange rate (¥ per $) — the dollar depreciates, and the yen appreciates. But the question asks about the shift, not the price change, so the answer is the supply of dollars increases.
Why the other options miss the mark
- (A) Backwards. With supply of dollars increasing, the dollar's price (¥ per $) falls — it takes fewer, not more, yen to buy a dollar.
- (B) Demand for dollars (from foreigners) is unchanged. Americans' preference for Japanese cars doesn't affect what foreigners want.
- (D) Supply increases (correctly), but demand doesn't decrease. Only one curve moves.
- (E) The FOREX market definitely changes — supply shifts and equilibrium moves.
🔗 Review: Re-read "Why Supply Slopes Upward" and the Scenario 2 worked example. The key habit: when an American consumer-preference shift is described, the dollar curve that moves is supply, not demand.
2. Assume that the inflation rate in Country X is very high relative to the inflation rates in all of its trading partners. Which of the following is likely to happen to Country X's currency on the foreign exchange market?
✓ Correct answer: (B)
When a country has high inflation relative to its trading partners, its goods become relatively expensive on world markets. Foreigners can buy similar goods more cheaply elsewhere, so they reduce purchases of Country X's exports. To buy fewer Country X exports, foreigners need fewer units of Country X's currency. Demand for the currency shifts left. With less demand at every price, the equilibrium exchange rate falls — the currency depreciates. (Note: the supply of Country X's currency would also shift right as Country X residents buy more imports — both effects depreciate the currency.)
Why the other options miss the mark
- (A) Wrong direction of demand shift. High inflation reduces demand for the currency, doesn't raise it.
- (C) Supply shifts right with high inflation (residents buy more imports), not left.
- (D) Right direction (depreciation), but wrong shift direction. Supply shifts right, not left.
- (E) The demand curve does shift in response to inflation. There would be no demand shift only if inflation didn't change foreigners' interest in the country's goods, which it does.
🔗 Review: Re-read the demand shifters table. High domestic inflation makes the country's goods relatively expensive → foreigners buy fewer → demand for currency falls → currency depreciates.
3. A FOREX diagram shows the dollar-yuan market with equilibrium at ¥7 per dollar. If the current exchange rate is being held at ¥6 per dollar, which of the following describes the current state of the market and the dollar's future movement under a flexible exchange rate system?
✓ Correct answer: (C)
The current price (¥6 per $) is below the equilibrium price (¥7 per $). The dollar is artificially cheap. At ¥6/$, foreigners want lots of dollars (high quantity demanded at this low price), but Americans don't want to sell many dollars at this low rate (low quantity supplied). Quantity demanded exceeds quantity supplied — this is a shortage of dollars. Under a flexible exchange rate system, a shortage means upward pressure on price. The exchange rate rises (more ¥ per $), meaning the dollar appreciates until reaching equilibrium at ¥7/$.
Why the other options miss the mark
- (A) Below-equilibrium price means shortage, not surplus. Direction (appreciation) is correct, but cause is wrong.
- (B) Wrong on both counts. There's a shortage (not surplus), and by the mirror rule, the yuan would appreciate, not depreciate, if the dollar depreciates. Since the dollar appreciates here, the yuan depreciates.
- (D) Right on shortage, wrong on direction. A shortage means upward pressure on price; the dollar appreciates, not depreciates.
- (E) ¥6/$ is below equilibrium, not at it. The market is not in balance at this price.
🔗 Review: Re-read "Surplus, Shortage, and the Wrong-Price Question." When the price of a currency is below equilibrium, there's a shortage of that currency, and its price will rise toward equilibrium.
4. An increase in Japan's demand for U.S. goods would cause the value of the dollar to
✓ Correct answer: (D)
Japan wants more U.S. goods. To buy U.S. exports, Japanese consumers and firms need dollars to pay U.S. sellers. To get dollars, they must convert yen into dollars on the FOREX market — i.e., they buy dollars (demand dollars). Demand for dollars shifts right. With higher demand for dollars at every price, the equilibrium price (¥ per $) rises, and the dollar appreciates. The logic: increased foreign demand for U.S. exports leads to increased foreign demand for the U.S. currency.
Why the other options miss the mark
- (A) Inflation isn't part of the story. Increased export demand doesn't cause inflation through this channel.
- (B) The U.S. is selling goods, not dollars. Japan is the party converting currency, and Japan is selling yen and demanding dollars.
- (C) Export sales don't increase the U.S. money supply. The money supply is controlled by the Fed, not by trade.
- (E) Japan is buying dollars (to pay for U.S. exports), not selling them.
🔗 Review: Re-read "Why Demand Slopes Downward" and the demand shifters table. The key insight: foreign demand for a country's exports creates foreign demand for the country's currency, which appreciates the currency.
5. Suppose the real interest rate in Canada rises relative to that in Mexico. Using a graph of the FOREX market for the Canadian dollar (expressed as Mexican pesos per Canadian dollar), which of the following best describes the change?
✓ Correct answer: (A)
Higher Canadian interest rates make Canadian assets more attractive than Mexican assets. The effects on FOREX:
(1) Mexicans and other foreign investors want to buy Canadian bonds for the higher returns. To do so, they need Canadian dollars → demand for Canadian dollars shifts right.
(2) Canadians find Canadian bonds more attractive than Mexican ones, so they invest less abroad. They sell fewer Canadian dollars on the FOREX market to obtain pesos → supply of Canadian dollars may shift left.
(3) Both effects push the price of the Canadian dollar (in pesos) up — the Canadian dollar appreciates.
This is the classic interest-rate-to-exchange-rate chain. The AP exam loves to test this exact relationship, and FRQ rubrics typically award full points for showing either the demand shift, the supply shift, or both, as long as the appreciation is clearly identified.
Why the other options miss the mark
- (B) Demand shifts right, not left. Higher Canadian rates attract foreign capital into Canada.
- (C) Supply may shift left, not right, as Canadians keep their money at home for higher returns. And the Canadian dollar appreciates, not depreciates.
- (D) The two shifts go in opposite directions (D right, S left), both pushing the price up. Ambiguous quantity, unambiguous price.
- (E) The FOREX market clearly responds to relative interest rate changes — there must be a shift.
🔗 Review: This is the canonical interest-rate-to-exchange-rate chain. On the AP exam FRQ, showing just the demand shift (D right) and labeling the appreciation typically earns full points. Drawing both shifts (D right and S left) is more thorough but not strictly required by most rubrics.
Ready for more? Take the full Unit 6 Practice Test →
End of Section 6.3. Up next: 6.4 Net Exports & Capital Flows — putting everything together: how fiscal and monetary policy ripple through interest rates, the FOREX market, net exports, and back into AD.