AP® Macroeconomics · Unit 6 · Topic 6.4
Income, Inflation, and Tastes in the Currency Market
Changes in income, inflation, and tastes shift the supply and demand curves for a currency by changing how much people want to buy or sell of that currency to trade goods. Higher domestic income or inflation tends to weaken a currency; foreigners wanting more of a country's goods tends to strengthen it.
The market for a currency works like any other market: a demand curve and a supply curve, with the exchange rate as the price. Demand for dollars comes from foreigners who want to buy US goods, services, or assets. Supply of dollars comes from Americans who want to buy foreign goods, services, or assets, and so are willing to trade their dollars away. Anything that changes how much Americans want to buy from abroad, or how much foreigners want to buy from the US, shifts one of these curves.
When US income rises, Americans buy more of everything, including imports. Buying imports means supplying more dollars to get foreign currency, so the supply of dollars shifts right and the dollar depreciates. Higher domestic inflation works through a different channel: US goods become more expensive relative to foreign goods. Foreigners want fewer expensive US exports, so demand for dollars falls, while Americans want more now-cheaper foreign goods, so supply of dollars rises. Both shifts push the dollar down together, which is why inflation is a double-barreled depreciator. A taste shift, like foreign tourists suddenly loving US vacations, raises demand for dollars directly, appreciating it.
This topic is the missing piece that completes the open economy loop. Interest rates pull financial capital across borders, and net exports pull goods across borders, but income, inflation, and tastes explain why that flow of goods changes in the first place. Together these three forces and interest rates are the full list of currency shifters, setting up exchange rate determination and its link back to the trade balance.
Key terms
- Demand for dollars
- The quantity of dollars foreigners want to buy, driven by their desire for US goods, services, and assets.
- Supply of dollars
- The quantity of dollars Americans offer in exchange markets to buy foreign currency for imports or foreign assets.
- Appreciation
- A rise in a currency's value relative to other currencies.
- Depreciation
- A fall in a currency's value relative to other currencies.
- Purchasing power parity logic
- The idea that relative price changes between countries drive relative demand for each other's goods and currencies.
Watch it explained
- How it worksHow does higher domestic inflation move both curves in the market for a currency?
- Going furtherWhat happens to the exchange rate when foreign tourists suddenly love visiting a country?
- Worked exampleFind the direction the dollar moves when US income rises while foreign income falls.
- Common mistakeWhy doesn't higher inflation at home make a currency more valuable abroad?
Check yourself
End of topic.