Foreign Exchange
Demand
Foreign exchange demand is the quantity of an international currency that all domestic and foreign currencies are willing and able to purchase at various rates of exchange. Either fortunately or unfortunately, supply and demand still come back even with foreign exchange.
Demand for the exchange market is not the same as demand for money. It's more about how much of a dollar is wanted in terms of euros. What does that mean? It means:
- Europeans want more of American goods and services
- Europeans want to invest in America Ever wonder why the exchange rate is always changing? It's because demand and supply of the dollar is changing constantly. Every second, foreigners might demand more or less for American products. This thus constitutes an increase (or decrease) in demand, changing the exchange rate again.
As we see here, because more Europeans want to buy American products, demand shifts right, and the exchange rate now increase from e to e1. Now, the American dollar is more expensive for Europeans to buy.
The relationship between exchange rates and the quantity of currency demanded is inverse:
💡As the exchange rate rises, domestic and foreign consumers will purchase less quantity of the currency.
💡As the exchange rate falls, domestic and foreign consumers will purchase more quantity of the currency.
Supply
Foreign exchange supply is the quantity of an international currency that all domestic and foreign sellers are willing and able to sell at various rates of exchange.
Supply in the foreign exchange market is upward sloping because if more dollars are supplied, then the price would be higher. It makes sense because if more people will be wanting to buy euros if they could buy more of them with a singular dollar. So when does supply change? It changes when:
- Americans want more European products
- Americans want to invest more in Europe If Americans buy a lot of French stuff, then they'll change trade in their dollars for euros. As a result, the supply of dollars will increase. If, however, the French buy more American stuff, the supply of dollar would decrease, as shown in the graph. This will cause a price increase for buying dollars from e1 to e2.
The relationship between exchange rates and quantity of currency supplied is positive or direct:
💡As exchange rates rise, domestic and foreign consumers are willing to sell more.
💡As exchange rates fall, domestic and foreign consumers are willing to sell less.
FOREX Market Equilibrium
Equilibrium is achieved in the FOREX Market (the market in which foreign currency is bought and sold) when the quantity supplied of the currency equals the quantity demanded of the currency at a specific exchange rate.
Let's draw the FOREX Market in Equilibrium for the EURO (💶) relative to the U.S. Dollar (💵):
Since in the FOREX market we are working with has flexible exchange rates, the exchange rates are constantly changing. When they rise above equilibrium or fall below equilibrium, the market will force them back up to equilibrium.
Connection to Monetary Policy
The exchange market also has some connection to monetary policies. Relative interest rates have a huge role on determining the exchange rate.
When the Fed increases the money supply, the interest rates on assets in the US fall, making the US a not-too-great-place-to-make-profit-from-investing place. Demand for the dollar will then fall and the dollar will depreciate.
But! The depreciating dollar will make goods in the US less expensive and therefore more attractive to foreign consumers. Then, net exports will increase, shifting AD to the right, and the dollar will appreciate.
On the other hand, when the Fed decreases the money supply, American interest rates will go up and investors will start investing in America. This will appreciate the dollar, but American goods will now be too expensive, resulting in a decrease in American exports, shifting AD to the left.
Confusing: When interest rates rise, there is a decrease in capital investment because it's more costly to borrow. However, we see an increase in financial investments (bonds) because income earned will increase.
Summary
Exchange rates fluctuate a lot, and currency appreciates and depreciates all the time. With everything is held constant, the demand for US dollar increases and the dollar appreciates relative to the euro if:
- Europeans develop a taste for American goods and want more of American stuff
- The relative income of Europeans rises so they want to spend more on American goods, increasing demand
- US goods are becoming cheaper as price level is falling, making American stuff inexpensive for Europeans to buy
- Experts and speculators believe the dollar will rise in value
- The interest rate in the US is higher than in Europe, making the US an attractive place to make profits off of bonds
Frequently Asked Questions
What is the foreign exchange market and how does it actually work?
The foreign exchange market is where currencies are bought and sold—the price is the exchange rate. Demand for a currency comes from foreigners who want that country’s goods, services, or financial assets; it falls as the exchange rate (price) rises (inverse relationship). Supply of a currency comes from residents who need foreign currency to buy foreign goods or invest abroad; it rises as the exchange rate rises (positive relationship). Equilibrium exchange rate is where quantity demanded = quantity supplied. If the rate is too high you get a surplus (pressure to depreciate); too low gives a shortage (pressure to appreciate) and market forces move the rate back to equilibrium. Shifts: higher foreign demand for exports or higher domestic interest rates (capital inflows) shift currency demand right → appreciation; more domestic spending on imports shifts supply right → depreciation. On the AP exam you should be able to draw and label these FX graphs and show adjustments (see the Topic 6.3 study guide for examples) (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO). For extra practice, use Fiveable’s practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
How do I read a foreign exchange graph - which axis is which?
Vertical axis = the exchange rate (the price of one currency in terms of another). Horizontal axis = quantity of that currency. Always read the axis label first (e.g., “$ per €” vs “€ per $”)—your interpretation of appreciation/depreciation depends on that label. Rules that match the CED: - Demand curve for a currency slopes downward: higher exchange rate → less quantity demanded (inverse relationship). (EK MKT-5.B.1) - Supply curve slopes upward: higher exchange rate → more quantity supplied (positive relationship). (EK MKT-5.B.2) - Equilibrium = where demand and supply cross (EK MKT-5.C.1). Quick tip for AP free-response: explicitly label the vertical axis (exchange rate: $/€ or €/$), label curves (D and S), and mark equilibrium—graders expect clear labels and correct direction of shifts. For more examples and practice, see the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and the Unit 6 overview (https://library.fiveable.me/ap-macroeconomics/unit-6).
Why does demand for currency slope downward but supply slopes upward?
Demand for a currency slopes downward because as the exchange rate (price of the foreign currency) falls, that currency gets cheaper for buyers, so foreigners demand more of its goods, services, and financial assets. That’s the inverse relationship in EK MKT-5.B.1: lower exchange rate → larger quantity demanded (more exports, more foreign investment into the country). Supply slopes upward because when the exchange rate rises (that currency is more expensive), domestic residents need more foreign currency to buy imports or invest abroad, so they supply more of their own currency to the FX market. That’s the positive relationship in EK MKT-5.B.2: higher exchange rate → larger quantity supplied. On the AP exam you should be ready to draw this: downward D, upward S, and show equilibrium where they meet (EK MKT-5.C.1). For more review, see the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO), the Unit 6 overview (https://library.fiveable.me/ap-macroeconomics/unit-6), and extra practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
I'm confused about what creates demand for a country's currency - can someone explain?
Demand for a country’s currency comes from foreigners wanting that currency to buy the country’s goods, services, and financial assets. If foreigners want your exports, pay for tourism, or buy your stocks/bonds, they must buy your currency—that creates demand. Higher foreign demand (e.g., because your interest rates are higher than abroad or your exports become cheaper) shifts the demand curve right and raises the exchange rate (currency appreciates). The CED stresses the inverse relationship: as the domestic currency’s price (exchange rate) falls, foreigners buy more of it (quantity demanded rises), and vice versa (EK MKT-5.B.1). Disequilibrium creates shortages/surpluses and market forces move the rate back to equilibrium. For AP review, see the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and more Unit 6 resources (https://library.fiveable.me/ap-macroeconomics/unit-6). Practice extra problems at (https://library.fiveable.me/practice/ap-macroeconomics).
What's the difference between exchange rate appreciation and depreciation?
Appreciation vs. depreciation are about a currency’s value in the foreign exchange market. Appreciation = the exchange rate rises (your currency buys more foreign currency). Depreciation = the exchange rate falls (your currency buys less foreign currency). In CED terms, appreciation happens when demand for a currency increases (rightward demand shift) or supply decreases, creating a shortage that pushes the exchange rate up to a new equilibrium. Depreciation happens when demand falls or supply increases, creating a surplus that drives the exchange rate down. Practically, an appreciation makes your exports more expensive and imports cheaper; a depreciation makes exports cheaper and imports more expensive. On the AP exam you should be able to show these on a foreign-exchange graph (labeled axes, supply and demand curves, and new equilibrium) and explain how market forces restore equilibrium. For a quick review, see the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and more unit resources (https://library.fiveable.me/ap-macroeconomics/unit-6). For practice, try the AP problem set (https://library.fiveable.me/practice/ap-macroeconomics).
How do I know if the dollar is getting stronger or weaker from a graph?
Look at the exchange-rate axis label first—that tells you what the number means. Then apply these rules: - If the vertical axis is “dollars per 1 unit of foreign currency” (price of foreign currency in dollars): an increase in the exchange rate (upward movement) means the dollar is weaker (you need more dollars to buy the same foreign currency). A decrease means the dollar is stronger. - If the axis is “foreign currency per 1 dollar” (price of the dollar in foreign currency): an increase means the dollar is stronger (one dollar now buys more foreign currency); a decrease means it’s weaker. On supply/demand graphs: a rightward shift in demand for the dollar (or movement along curves raising the exchange rate in the “foreign per dollar” graph) shows appreciation; a rightward shift in supply of dollars causes depreciation. On the AP FRQ you must label axes, show shifts/movements, and state appreciation or depreciation to get full credit (see Topic 6.3 study guide) (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO). For extra practice, try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
What happens when there's a surplus or shortage in the foreign exchange market?
A surplus in the foreign exchange market means quantity supplied of a currency > quantity demanded at the current exchange rate. That excess supply puts downward pressure on the exchange rate (the currency depreciates). As the rate falls, foreign buyers demand more of the currency’s goods and investors buy the currency, and sellers supply less—moving the market back to equilibrium. A shortage is the opposite: quantity demanded > quantity supplied at the current rate, which pushes the exchange rate up (the currency appreciates). Rising rates reduce foreign demand for the country’s goods/assets and increase supply until demand = supply. On the AP exam you should be able to show this on a demand–supply graph and explain how market forces restore equilibrium (CED EK MKT-5.C/D). For more review see the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
Why would people want to buy more of a currency when its price goes down?
Because a lower price means that currency is cheaper relative to your own, so each unit of your money buys more of it—making that country’s goods, services, and financial assets cheaper for you. In the foreign-exchange market this drives up the quantity demanded: importers, tourists, and foreign investors buy more of the cheaper currency to buy exports, travel, or to buy financial assets (or to speculate if they expect it to rebound). That inverse relationship is exactly what EK MKT-5.B.1 describes: as the exchange rate falls (currency depreciates), quantity demanded rises. On AP free-response you may be asked to draw this: a downward-sloping demand curve for the currency, an upward-sloping supply curve, and show how changes create shortages/surpluses until equilibrium restores (EK MKT-5.C / 5.D). For a quick review, check the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and practice FX graphs at Fiveable’s Unit 6 page (https://library.fiveable.me/ap-macroeconomics/unit-6).
How does equilibrium work in foreign exchange markets compared to regular supply and demand?
Equilibrium in the foreign exchange market works like any supply-and-demand market, but the “price” is an exchange rate (how much foreign currency you get per domestic currency). Demand for a currency comes from foreigners who want your goods, services, or financial assets (so demand slopes downward: a lower exchange rate → more foreign buyers). Supply comes from residents buying imports or investing abroad (supply slopes upward: a higher exchange rate → more domestic sellers). Equilibrium exchange rate is where quantity demanded = quantity supplied; if the rate is above equilibrium you get a surplus (downward pressure → depreciation), if below you get a shortage (upward pressure → appreciation). Interest-rate changes, capital flows, and expectations shift demand or supply and move the rate back to equilibrium. On the AP FRQ you’ll need to draw these curves, show shifts, and explain appreciation/depreciation (see CED EK MKT-5.B–D). For a clear review and practice questions, check Fiveable’s Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and the unit practice bank (https://library.fiveable.me/practice/ap-macroeconomics).
I don't understand how exchange rates adjust back to equilibrium - help?
Think of the FX market like any supply-and-demand market: the exchange rate adjusts until quantity demanded = quantity supplied (CED EK MKT-5.C.1). If demand for your currency exceeds supply, your currency appreciates; if supply exceeds demand, it depreciates (EK MKT-5.B.1, EK MKT-5.B.2). Mechanism: a shortage (demand > supply) pushes the exchange rate up (currency value rises). That appreciation makes your exports more expensive and imports cheaper, so foreign buyers demand less of your currency and domestic residents supply more—demand falls and supply rises until equilibrium is restored. A surplus (supply > demand) works the opposite way: depreciation makes exports cheaper, increasing foreign demand for your currency until quantity demanded equals quantity supplied. Interest-rate changes and capital flows shift demand/supply curves (higher domestic rates → capital inflows → demand shift right → appreciation). On the AP exam you should draw the FX graph and show shifts (Topic 6.3). For a quick refresher, see the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and try practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What causes the supply curve for currency to shift right or left?
The supply of a currency shifts when residents change how much domestic currency they sell to get foreign currency. Rightward shift (more supply of domestic currency): domestic buyers want more foreign goods, services, or assets—e.g., higher domestic income → more imports, capital outflows as investors buy foreign assets, or expectations that the domestic currency will depreciate (so people sell now). Leftward shift (less supply): residents buy fewer foreign things or investors bring money back home—e.g., lower import demand, capital inflows because foreign investors buy domestic assets, or higher domestic interest rates that make holding domestic assets more attractive. Remember EK MKT-5.B.2: supply comes from making payments in other currencies. These shifts change equilibrium exchange rates (appreciation/depreciation) and are tested on the AP (use FX graphs in free-response). For extra practice, see the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and more problems at (https://library.fiveable.me/practice/ap-macroeconomics).
How do imports and exports affect demand for currency?
When foreigners buy your country’s exports, they need your currency to pay—so demand for your currency rises (demand curve shifts right). Higher demand tends to raise the exchange rate (your currency appreciates). By the CED: “demand for a currency arises from demand for the country’s goods, services, and financial assets” (EK MKT-5.B.1). When your residents buy imports, they sell your currency to get foreign currency, which increases the supply of your currency in the FX market (supply curve shifts right). That increased supply tends to lower the exchange rate (your currency depreciates) (EK MKT-5.B.2). On a graph, equilibrium is where demand = supply; shifts cause shortages or surpluses and market forces move the rate back to equilibrium (EK MKT-5.C.1, EK MKT-5.D.1). Remember: appreciation makes exports less competitive (exports fall); depreciation makes exports cheaper (exports rise). For more on graphs and AP-style explanations, see the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
When the exchange rate increases, why does quantity supplied of currency increase too?
Think of the supply of a currency as people selling that currency to get foreign currency (to buy imports or invest abroad). The CED says the supply curve has a positive slope: when the exchange rate rises, the quantity supplied of that currency increases (EK MKT-5.B.2). Why? If the exchange rate rises (so each unit of the domestic currency can buy more foreign currency), sellers get more foreign currency for every unit they sell—making conversions cheaper/more attractive. Importers and investors who need foreign currency will therefore sell more domestic currency now. Graphically, a higher exchange rate is a movement up along the supply curve, producing a larger quantity supplied. Disequilibrium (surplus/shortage) then pushes the rate toward the point where supply equals demand (EK MKT-5.C.1, EK MKT-5.D.1), which is exactly what you’ll need to show on AP free-response graphs. If you want a quick refresher and practice graph questions, check the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and more practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What's the relationship between a country's financial assets and demand for its currency?
Demand for a country’s currency comes from foreigners wanting that country’s goods, services, or financial assets (EK MKT-5.B.1). So when foreigners want more of a country’s bonds, stocks, or other financial assets—often because its interest rates or expected returns are higher—demand for that country’s currency rises. On a forex graph the demand curve shifts right, the exchange rate rises (currency appreciates), and the quantity exchanged increases. That appreciation makes exports more expensive and imports cheaper, and market forces then push toward a new equilibrium (EK MKT-5.C.1; MKT-5.D.1). For AP practice, be ready to show this with a demand/supply graph of the foreign exchange market and link capital flows to interest-rate differentials. Review the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
How do I analyze what happens to exchange rates when both supply and demand shift?
Think of the foreign exchange market like any supply-and-demand graph for a currency (CED: demand from foreigners buying your goods/assets; supply from residents buying foreign stuff). When both curves shift, do this: 1) Draw it. Label exchange rate (price of your currency) on vertical axis and quantity on horizontal. 2) Ask: which direction does each shift move the exchange rate? - If demand and supply move the same way, that variable is clear: - Both increase → quantity ↑, exchange rate (price) is indeterminate (depends on magnitudes). - Both decrease → quantity ↓, price indeterminate. - If they move opposite ways, price is clear, quantity is indeterminate: - Demand ↑ and supply ↓ → price (currency) appreciates; quantity ambiguous. - Demand ↓ and supply ↑ → price depreciates; quantity ambiguous. 3) If you need a unique answer, state which shift is larger (e.g., demand increases more than supply → appreciation and quantity rises). On the AP, draw the graph and state indeterminate vs. known outcomes (CED EK MKT-5.C/D). For extra practice, use the Topic 6.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-6/foreign-exchange-market/study-guide/WTPlTJgd7wSsnRl17knO) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).