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The foreign exchange market model

Understanding and creating graphs are critical skills in macroeconomics. In this article, you’ll get a quick review of the foreign exchange market model, including:
  1. what it’s used to illustrate
  2. key elements of the model
  3. some examples of questions that can be answered using that model.

What the foreign exchange model illustrates

Exchange rates are determined by the interaction of people who want to trade in their currency (the supply of a currency) with other people who want to obtain that currency (the demand for a currency). The foreign exchange model is a variation on a market model.

Key Features of the foreign exchange model

  • A horizontal axis labeled with the quantity of the currency that is being exchanged. For example, if it’s the foreign exchange market for the Euro, the correct label would be Q, start subscript, e, u, r, o, end subscript
  • A vertical axis labeled with the exchange rate of a currency. Remember that a currency is always priced in terms of some other currency.
A downward sloping demand for the currency, labeled "D, start subscript, e, u, r, o, end subscript” and an upward sloping supply of the currency, labeled "S, start subscript, e, u, r, o, end subscript"
  • An equilibrium exchange rate, labeled "ER"

Helpful reminders for the foreign exchange model

Make it clear what market you are in by using the correct labels. It can be easy to confuse the money market with the currency market, since many people think of currency as money. But the money market is about willingness to hold money, not willingness to exchange money.

An example of a use of the foreign exchange model: showing the impact of deficits on exchange rates

Recall that when a government runs a budget deficit, the real interest rate will increase. A higher real interest rate will encourage savers in other countries to buy financial assets in that country. To do so, foreign savers will need to buy that country’s currency in order to buy those financial assets. As a result, the demand for the currency, and the exchange rate, increases.
For example, suppose countries in Europe ran a budget deficit, increasing real interest rates in Europe. As a result, people in Mexico would want to buy financial assets in Europe and would need euros in order to do so. As a result, the demand for the euro increases and the euro appreciates, as shown in the graph below:

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