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Lesson summary: Changes in the foreign exchange markets and net exports

MKT‑5 (EU)
MKT‑5.F (LO)
MKT‑5.F.1 (EK)
MKT‑5.F.2 (EK)
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 C, plus, G, plus, I, plus, X, minus, M.
That “X, minus, M” is net exports. Anything that can cause a currency to appreciate or depreciate can impact net exports. When a currency appreciates, its goods are more expensive to the rest of the world.

Key terms

Key termDefinition
open economyan 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 (S, N) and the demand for the Atlantian dollar increases. As a result of these actions, the snark depreciates, and the dollar appreciates.
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.
  1. Draw a correctly labeled graph showing the economy of Wizbaland in a recession, showing:
a. The current price level labeled P, L, start subscript, 1, end subscript and the current output labeled Y, start subscript, 1, end subscript.
b. The full employment rate of output labeled Y, start subscript, f, end subscript.
  1. Name an appropriate fiscal policy action that would increase output.
  2. 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.
  3. What will happen to net exports as a result of the change in the interest rate you indicated in part (3). Explain.
  4. 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?

  • blobby green style avatar for user Gandalf the Padawan
    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)
    (3 votes)
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  • starky ultimate style avatar for user Ethan Lin
    What shifts in the graph when the interest rate increase in a certain country relative to another currency?
    (2 votes)
    Default Khan Academy avatar avatar for user