United StatesEconomicsSyllabus dot point

What shifts the supply of and demand for a currency in the foreign exchange market?

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.

Generated by Claude Opus 4.812 min answerUpdated 2026-06-04

Reviewed by: AI editorial process; not yet individually human-reviewed

Have a quick question? Jump to the Q&A page

Quick answer

The exchange rate changes when something shifts the supply of or demand for a currency. The main determinants are: relative interest rates (higher domestic rates attract foreign capital, raising demand for the currency and causing appreciation), relative income (higher domestic income raises demand for imports, increasing the supply of domestic currency and causing depreciation), relative price levels (higher domestic inflation makes the country's goods dearer, lowering demand for its currency), tastes and preferences for each country's goods, and speculation or expectations about future exchange rates. Monetary policy works through interest rates: expansionary policy lowers domestic rates, causing the currency to depreciate, which raises net exports and reinforces the policy; contractionary policy does the reverse.

Jump to a section

What this topic is asking
The determinants of currency supply and demand
Monetary policy and the exchange rate
Try this

What this topic is asking

Topic 6.4 covers what shifts currency supply and demand in the foreign exchange market. The College Board wants you to identify the determinants, relative interest rates, relative income, relative prices, tastes, and speculation, and to trace how monetary policy moves exchange rates. This connects the forex market to the rest of macro.

The determinants of currency supply and demand

Key fact

The foreign exchange market shifts when these determinants change:

Relative interest rates. Higher domestic interest rates (relative to abroad) make the country's assets more attractive, so foreign investors demand more of the currency, it appreciates. Lower relative rates cause depreciation. This is the strongest and most-tested channel.
Relative income. Higher domestic income raises domestic demand for imports, so residents supply more of their currency to buy foreign goods, it depreciates. Higher foreign income raises foreign demand for the country's exports, raising demand for the currency.
Relative price levels (inflation). Higher domestic inflation makes the country's goods relatively expensive, lowering demand for its currency, depreciation.
Tastes and preferences. A stronger foreign taste for the country's goods raises demand for its currency.
Speculation and expectations. If investors expect the currency to appreciate, they demand it now, causing appreciation.

Monetary policy and the exchange rate

This is the key policy link AP tests. Monetary policy moves the exchange rate through interest rates:

So monetary policy has both a domestic channel (interest rate to investment) and an international channel (interest rate to exchange rate to net exports), and for expansionary policy both channels push aggregate demand the same way.

Higher relative interest rates and appreciation

The domestic central bank raises interest rates well above those abroad. Trace the effect in the foreign exchange market and on net exports.

step 1 Draw the market

Vertical axis: the exchange rate (price of the domestic currency). Horizontal axis: quantity of the domestic currency. Draw downward-sloping demand $D_1$ and upward-sloping supply $S$ , crossing at exchange rate $e_1$ .

step 2 Apply the interest-rate change

Higher domestic interest rates make domestic bonds and assets more attractive to foreign investors. They need the domestic currency to buy these assets, so the demand for the currency rises.

step 3 Shift demand right

Shift demand from $D_1$ to $D_2$ . The equilibrium exchange rate rises to $e_2$ : the currency appreciates.

step 4 Effect on net exports

A stronger currency makes exports dearer for foreigners and imports cheaper at home, so net exports fall. This is why a contractionary, high-rate policy both cools domestic demand and reduces net exports.

Try this

Q1. A country's interest rates rise relative to the rest of the world. Does its currency appreciate or depreciate? [1 point]

Cue. It appreciates (foreign capital flows in, raising demand for the currency).

Q2. How does higher domestic income affect the exchange rate? [2 points]

Cue. Higher income raises import demand, increasing the supply of domestic currency, so the currency depreciates.

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 2019 (style)1 marksMultiple choice. If the domestic central bank raises interest rates relative to other countries, in the foreign exchange market for the domestic currency the most likely effect is (A) demand for the currency falls and it depreciates. (B) demand for the currency rises and it appreciates. (C) supply of the currency rises and it depreciates. (D) no change, because interest rates do not affect currencies. (E) the currency appreciates only if exports rise.

Show worked answer →

The answer is (B). Higher relative interest rates make the country's assets more attractive to foreign investors seeking higher returns. They demand more of the domestic currency to buy those assets, so demand shifts right and the currency appreciates.

(A) and (C) have the wrong direction. (D) is false; interest rates strongly affect capital flows and currencies. (E) wrongly limits the channel; the effect works through capital flows, not just exports. Higher relative rates cause appreciation, so (B).

AP 2021 (style)6 marksFree response. The domestic central bank conducts expansionary monetary policy. (a) State the effect on the domestic nominal interest rate. (b) Explain how this affects foreign demand for the domestic currency. (c) Draw a correctly labelled foreign exchange market graph for the domestic currency and show the effect. (d) State whether the currency appreciates or depreciates. (e) Explain the effect on the country's net exports. (f) State how this reinforces the effect of expansionary monetary policy on aggregate demand.

Show worked answer →

A 6-point chained FRQ.

(a) Interest rate (1 point): expansionary monetary policy lowers the domestic nominal interest rate.

(b) Demand for currency (1 point): lower relative interest rates make domestic assets less attractive, so foreign demand for the domestic currency falls (and domestic supply may rise as residents seek higher returns abroad).

(c) Graph (1 point): exchange rate on the vertical axis, quantity of the domestic currency on the horizontal axis; demand shifting left (or supply shifting right).

(d) Result (1 point): the domestic currency depreciates.

(e) Net exports (1 point): a weaker currency makes exports cheaper and imports dearer, so net exports rise.

(f) Reinforcement (1 point): higher net exports add to aggregate demand, reinforcing the expansionary effect of the lower interest rate on investment.

Markers reward the lower rate, the fall in currency demand, the depreciation, the rise in net exports, and the reinforced AD effect.

Related dot points

Sources & how we know this

AP Macroeconomics Course and Exam Description — College Board (2023)