1. Monetary Policy under Flexible Exchange Rates★★☆☆☆⏱ 3 min

Monetary policy impacts the foreign exchange market primarily through the interest rate effect. Expansionary monetary policy increases the domestic money supply, lowering short-run nominal and real interest rates. Lower domestic interest rates mean foreign assets have higher relative returns, causing two parallel shifts: domestic investors supply more domestic currency to buy foreign assets, and foreign investors demand less domestic currency to buy domestic assets.

Both shifts lead to domestic currency depreciation, which makes exports cheaper for foreigners and imports more expensive for domestic consumers, increasing net exports and boosting aggregate demand. Contractionary monetary policy has the opposite effect: higher interest rates lead to currency appreciation, lower net exports, and reduced aggregate demand, a core result of the Mundell-Fleming model.

2. Fiscal Policy under Flexible Exchange Rates★★★☆☆⏱ 4 min

Expansionary fiscal policy (increased government spending or tax cuts) increases domestic aggregate demand and income, and raises domestic interest rates as increased government borrowing pushes up market rates. Higher domestic interest rates attract foreign capital, increasing demand for domestic currency and leading to appreciation. At the same time, higher domestic income increases demand for imports, increasing the supply of domestic currency on the forex market.

In the short run, the interest rate effect dominates the income effect, leading to net currency appreciation. Appreciation reduces net exports, offsetting some of the expansionary effect of fiscal policy, an outcome called crowding out of net exports. Contractionary fiscal policy has the opposite effect: lower interest rates lead to depreciation, higher net exports, and offset the initial contraction.

3. External Shocks to the Foreign Exchange Market★★☆☆☆⏱ 3 min

External shocks are unanticipated changes in economic conditions or preferences that shift currency supply or demand independent of intentional domestic policy. Common shocks tested on the AP exam include changes in foreign income, relative price levels, consumer tastes, foreign interest rates, and expected future exchange rates. The same supply and demand framework applies to all shocks: identify who changes their behavior, which curve shifts, and the resulting change in the exchange rate.

• Change in foreign income: Higher foreign income increases demand for domestic exports → domestic currency appreciation

• Change in relative price levels: Faster domestic inflation makes domestic goods more expensive → domestic currency depreciation

• Change in consumer tastes: Shift toward domestic goods increases export demand → domestic currency appreciation

• Change in foreign interest rates: Higher foreign interest rates cause capital outflow → domestic currency depreciation

4. Policy and Shocks under Fixed Exchange Rates★★★★☆⏱ 4 min

Under a fixed exchange rate regime, the central bank pegs the value of the domestic currency at a specific target exchange rate against a foreign currency (usually the U.S. dollar). If a policy change or external shock pushes the free-market equilibrium exchange rate away from the target, the central bank must intervene in the forex market to maintain the peg.

If a shock leads to downward pressure on the domestic currency (the free-market value is below the target), the central bank buys domestic currency and sells foreign reserves to push the rate back up. If the currency faces upward pressure to appreciate, the central bank sells domestic currency and buys foreign reserves to keep the rate at target. A key result: monetary policy is ineffective under fixed rates (any money supply change is offset by intervention), while fiscal policy is highly effective (crowding out of net exports is eliminated).

5. Concept Check