How do exchange-rate changes feed through to net exports and aggregate demand?
Topic 6.5 Changes in the Foreign Exchange Market and Net Exports: explain how appreciation and depreciation change net exports, and trace the effect on aggregate demand.
A focused answer to AP Macroeconomics Topic 6.5, covering how currency appreciation and depreciation change exports and imports, the effect on net exports, and how this feeds through the foreign exchange market into aggregate demand and the AD-AS model, with a worked chained question.
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What this topic is asking
Topic 6.5 closes the loop between the foreign exchange market and the domestic economy: how exchange-rate changes feed through to net exports and then to aggregate demand. The College Board wants you to chain three diagrams, the forex market, net exports, and AD-AS, a classic multi-part free-response structure.
From the exchange rate to net exports
From net exports to aggregate demand
Net exports are one of the four components of aggregate demand, . So a change in net exports shifts AD:
The full chain
A complete free-response answer usually moves through three diagrams in order: (1) the foreign exchange market, where some event shifts currency supply or demand and changes the exchange rate; (2) the resulting change in net exports; (3) the AD-AS model, where the change in net exports shifts aggregate demand and changes output and the price level.
Try this
Q1. A currency appreciates. What happens to net exports? [1 point]
- Cue. Net exports fall (exports dearer, imports cheaper).
Q2. How does a depreciation affect aggregate demand? [2 points]
- Cue. It raises net exports, which shifts aggregate demand right, raising output and the price level.
Exam-style practice questions
Practice questions written in the style of College Board exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
AP 2018 (style)1 marksMultiple choice. A depreciation of the domestic currency will, all else equal, (A) lower net exports and shift aggregate demand left. (B) raise net exports and shift aggregate demand right. (C) leave net exports unchanged. (D) raise imports and lower exports. (E) shift long-run aggregate supply right.Show worked answer →
The answer is (B). A weaker (depreciated) domestic currency makes the country's exports cheaper for foreigners and imports more expensive at home, so exports rise and imports fall. Net exports rise, which is a component of aggregate demand, so AD shifts right.
(A) and (D) have the direction backwards. (C) ignores the trade effect. (E) confuses a demand change with a capacity change. Depreciation raises net exports and shifts AD right, so (B).
AP 2021 (style)5 marksFree response. Foreign demand for the country's currency falls. (a) Draw a correctly labelled foreign exchange market graph and show the effect on the exchange rate. (b) State whether the currency appreciates or depreciates. (c) Explain the effect on exports and imports. (d) State the effect on net exports. (e) On a separate AD-AS graph, show the effect on aggregate demand, output, and the price level.Show worked answer →
A 5-point chained FRQ.
(a) Graph (1 point): exchange rate on the vertical axis, quantity of currency on the horizontal axis; demand shifting left, lowering the exchange rate.
(b) Result (1 point): the currency depreciates.
(c) Exports and imports (1 point): a weaker currency makes exports cheaper for foreigners (exports rise) and imports more expensive (imports fall).
(d) Net exports (1 point): net exports rise.
(e) AD-AS (1 point): higher net exports shift aggregate demand right, raising real output and the price level.
Markers reward the leftward demand shift, the depreciation, the rise in net exports, and the rightward AD shift with higher output and prices.
Related dot points
- Topic 6.2 Exchange Rates: define the nominal exchange rate, distinguish appreciation from depreciation, and calculate exchange rates between two currencies.
A focused answer to AP Macroeconomics Topic 6.2, covering the definition of the exchange rate, currency appreciation and depreciation, how to convert between currencies, and the effect of exchange-rate changes on the relative price of goods, with full worked calculations.
- Topic 6.3 The Foreign Exchange Market: draw the foreign exchange market for a currency, explain the supply of and demand for it, and find the equilibrium exchange rate.
A focused answer to AP Macroeconomics Topic 6.3, covering the supply of and demand for a currency in the foreign exchange market, the equilibrium exchange rate, what each curve represents, and how to read appreciation and depreciation off the graph, with a worked graphing question.
- Topic 6.4 Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market: identify the determinants that shift currency supply and demand, including interest rates, income, prices, and tastes.
A focused answer to AP Macroeconomics Topic 6.4, covering the determinants that shift currency supply and demand in the foreign exchange market, including relative interest rates, relative income, relative price levels, tastes, and speculation, and how monetary policy moves exchange rates, with a worked graphing question.
- Topic 3.1 Aggregate Demand: define aggregate demand, explain the wealth, interest-rate, and exchange-rate effects that make it downward sloping, and identify the determinants that shift it.
A focused answer to AP Macroeconomics Topic 3.1, covering the definition of aggregate demand, the three reasons it slopes downward (the wealth, interest-rate, and exchange-rate effects), the components C plus I plus G plus net exports, and the determinants that shift the curve, with a worked graphing question.
- Topic 3.6 Changes in the AD-AS Model in the Short Run: trace how shifts in aggregate demand or short-run aggregate supply change the price level, real output, and unemployment in the short run.
A focused answer to AP Macroeconomics Topic 3.6, covering demand shocks and supply shocks in the short run, their effects on the price level, real output, and unemployment, and how to read the resulting output gaps, with a worked graphing question.
Sources & how we know this
- AP Macroeconomics Course and Exam Description — College Board (2023)