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Course: AP®︎/College Macroeconomics > Unit 6
Lesson 5: Changes in the foreign exchange markets and net exportsLesson summary: Changes in the foreign exchange markets and net exports
In this lesson summary review and remind yourself of the key terms and graphs related to how changes in foreign exchange markets affect net exports in each country.
Lesson Summary
Changes in the exchange rate of a currency doesn’t just impact your vacation plans, its impacts real GDP. Remember that aggregate demand is comprised of
That “
Key terms
| Key term | Definition |
|---|---|
| open economy | an economy that allows the exchange of both goods and assets with other countries |
Key takeaways
Anything that changes the value of a currency changes net exports
When a currency appreciates, its goods are more expensive to other countries. When a currency depreciates, its goods are less expensive to other countries. Therefore, anything that changes a currency’s value can impact real GDP, unemployment, and the price level.
For example, let’s take a look at the I from our TIPSY mnemonic (which stands for relative interest rates) and take one last trip to Hamsterville.
If interest rates in Hamsterville decrease, saving your money in Hamsterville doesn’t sound like such a great idea. If Hamsterville is an open economy, people in Hamsterville will want to hold financial assets somewhere else, like Atlantis, because the interest rate there is now relatively higher.
To buy the Atlantian bonds, Hamsterville will need some Atlantian dollars to buy those bonds. They increase the supply of the Hamsterville snark (
As a result of the depreciated snark, all of the hamster food, shiny salamander stickers, and any other good produced in Hamsterville are relatively cheaper in Atlantis. Exports from Hamsterville increase. At the same time, all of the goods made in Atlantis are far more expensive for Hamsterville, so it imports less of those goods. As a result, net exports increase. When net exports increase, so does aggregate demand.
Common misperceptions
- A lot of people assume that a “strong currency” is a good thing, but that is not necessarily true. A strong currency means that it has worth relatively more compared to other currencies. That might be a good thing if you want to keep the costs of imports low. But, it also comes at a cost. A strong currency means a country exports less, and has lower net exports. Therefore, a strong currency can potentially lower real GDP.
Questions for review
The economy of Wizbaland is experiencing a recession.
- Draw a correctly labeled graph showing the economy of Wizbaland in a recession, showing:
a. The current price level labeled
b. The full employment rate of output labeled
- Name an appropriate fiscal policy action that would increase output.
- The economy of Wizbaland had a balanced budget prior to the impact of the fiscal policy action you named in part b. Show the impact of that action on a correctly labeled graph of the loanable funds market.
- What will happen to net exports as a result of the change in the interest rate you indicated in part (3). Explain.
- If the central bank wants to take an appropriate monetary policy to counteract the impact on net exports that you described in 4, what open market operation would be appropriate? Explain.
Want to join the conversation?
I have a questions regarding the relationship of interest rates and the economic cycle (recession vs. recovery):
In a recession:
a) Is it the aim of fiscal policy to maintain low interest rates? And if not, what is its aim?
b) Is it the aim of monetary policy to maintain low interes rates?
In general:
c) Is there a general relationship between interest rates and the economic cycle (recession/recovery)?
for more detail check out my thoughts below ;)
In the review questions here we have to deal with a recession, in which the autorities should take fiscal policies such as an (1) increase in government spending or a (2) decrease in taxes.
It makes sense, that this would lead to increased interest rates as either (1) the government has to engage in borrowing money or (2) people have more money to e.g. deposit in banks.
I see how this increases aggregate demand and thus boosts the economy.
However I thought, that it would be benefical during a recession to decrease the interest rates, so that it becomes attractive for e.g. businesses to get loans, invest and thus boost the economy.
Is that not the case?
Or ist that only the aim of monetary policy?? (monetary policy: e.g. increse money supply during a recession --> decreases interest rates --> increases investment --> increses aggregate demand)(5 votes)- a) In a recession, the aim of fiscal policy is not necessarily to maintain low interest rates. Fiscal policy focuses on stimulating the economy through government spending or tax measures. Increasing government spending or decreasing taxes can increase aggregate demand and stimulate economic activity. This increased demand may lead to increased borrowing by the government, which could put upward pressure on interest rates.
b) On the other hand, during a recession, the aim of monetary policy is often to maintain low interest rates. The central bank, which is responsible for monetary policy, can lower interest rates by decreasing the target for the short-term interest rate (such as the federal funds rate in the United States). Lower interest rates encourage borrowing and investment by businesses and individuals, which can help stimulate economic growth and recovery.
c) Generally, there is an inverse relationship between interest rates and the economic cycle. During a recession, central banks often lower interest rates to stimulate borrowing, investment, and consumption. Lower interest rates can make it more attractive for businesses and individuals to take out loans and invest, which can help boost economic activity. Conversely, during a recovery or expansion phase of the economic cycle, central banks may raise interest rates to prevent excessive borrowing and spending, which could lead to inflationary pressures.
In summary, fiscal policy and monetary policy have different aims during a recession. Fiscal policy focuses on stimulating the economy through government spending or tax measures, which can affect interest rates indirectly. Monetary policy, on the other hand, aims to directly influence interest rates to stimulate borrowing and investment. Both policies can play a role in stabilizing the business cycle, but they operate through different mechanisms and have different tools at their disposal. The choice of policy measures depends on the specific needs and conditions of the economy.(3 votes)
What shifts in the graph when the interest rate increase in a certain country relative to another currency?(2 votes)- In which graph? There are a ton of them in Macro :)(1 vote)