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AP Macroeconomics · Unit 6 of 6

Open Economy

10–13% of the exam8 lessons · 112 min52 terms
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What this unit covers

The topics below follow the published Macro course framework for Unit 6. This unit is worth 10–13% of the exam, so budget your time against that rather than against how long the unit takes to teach.

Balance of paymentsExchange ratesTradeCapital flows

Lessons in this unit

Formulas in Unit 6

Balance of payments identity
Current account + Financial (capital) account ≈ 0
A current account deficit is matched by a financial account surplus (net capital inflow), and vice versa. The two accounts offset.
Exchange rate movements
Increase in demand for a currency ⇒ appreciation · Increase in supply of a currency ⇒ depreciation
One currency’s appreciation is the other’s depreciation. Appreciation raises export prices and lowers import prices; depreciation does the reverse.
The interest rate → exchange rate → net exports chain
Domestic real interest rate ↑ → capital inflow → currency appreciates → net exports ↓ → AD ↓
Reverse every arrow when the domestic interest rate falls: capital outflow, depreciation, higher net exports, AD up.
The balance of payments identity
current account + financial account ≈ 0 → CA deficit ⇔ FA surplus
Approximately, because of statistical discrepancies. Conceptually exact: a country that imports more than it exports must sell assets or borrow to cover the gap.
The mirror rule
dollar appreciates ⇔ euro depreciates · demand for dollars ↑ ⇔ supply of euros ↑
Buying dollars with euros is simultaneously demanding dollars and supplying euros — one transaction, two graphs.
The monetary chain, extended
MS ↑ → nominal rate ↓ → (a) investment ↑ and (b) capital outflow → currency depreciates → Xn ↑ → both raise AD
Two channels, same direction. This is why monetary policy is often described as more powerful in an open economy.
The capital flow rule
capital flows toward the higher expected REAL return → inflow shifts loanable funds SUPPLY right → domestic real rate falls
This is the link between Unit 6 and the Unit 4 loanable funds graph.
The consistency checks
real GDP ↑ ⇒ unemployment ↓, money demand ↑, nominal rate ↑ · real rate ↑ ⇒ investment ↓, capital inflow, currency appreciates, Xn ↓
If any two of your answers violate these, one of them is wrong. Use it as a self-check before moving on.

Every term in Unit 6

All 52 terms we publish for Open Economy, with definitions. Reading them through is the fastest way to find the ones you cannot define — then drill those in cram mode until you can produce them without the prompt.

Balance of payments
A record of all transactions between a country and the rest of the world, split into the current account and the capital and financial account. The two must sum to zero.
Current account
Net exports of goods and services, plus net investment income and net transfers. A trade deficit is a current-account deficit.
Capital and financial account
Net purchases of assets across borders — foreign direct investment, portfolio flows, and official reserves. It records who is lending to whom.
Why the accounts offset
Every dollar leaving as payment for imports must return as a purchase of domestic assets or goods. A current-account deficit is financed by a financial-account surplus.
Foreign exchange market
Where currencies are traded. Demand for a currency comes from foreigners wanting its goods and assets; supply comes from domestic residents wanting foreign goods and assets.
Appreciation
A currency rises in value against another — it buys more foreign currency. Exports become dearer abroad and imports cheaper at home, so net exports fall.
Depreciation
A currency falls in value against another. Exports become cheaper abroad and imports dearer at home, so net exports rise.
Reading a forex graph
The axes are the exchange rate (price of the currency in foreign currency) and the quantity of that currency. Every question has two graphs, and a change in one must be shown in the other.
What raises demand for a currency
Higher foreign income, a taste shift toward its exports, higher domestic real interest rates, and expectations that it will appreciate.
What raises supply of a currency
Higher domestic income (more imports), a taste shift toward foreign goods, higher foreign real interest rates, and expectations of depreciation.
Interest rates and exchange rates
A rise in the domestic real interest rate attracts foreign capital, raising demand for the currency, which appreciates and reduces net exports. The chain that links monetary policy to trade.
The full contractionary-policy open-economy chain
Fed sells bonds → MS falls → nominal and real rates rise → foreign capital inflow → demand for the dollar rises → dollar appreciates → exports fall and imports rise → net exports fall → AD shifts left further.
Floating exchange rate
Set by supply and demand in the foreign exchange market with no official target. Most major currencies float, and the rate absorbs shocks that would otherwise hit output.
Fixed (pegged) exchange rate
The government commits to a rate and buys or sells reserves to hold it. Constrains monetary policy, since domestic rates must serve the peg.
Real vs nominal exchange rate
The nominal rate is the market price of one currency in another. The real rate adjusts for relative price levels and is what determines competitiveness.
Net exports (Xn)
Exports minus imports. A component of AD, so anything that moves it — foreign income, exchange rates, relative price levels, trade policy — shifts AD.
Trade deficit
Imports exceed exports. Necessarily matched by a net capital inflow, which is why it is not straightforwardly a sign of weakness.
Tariff
A tax on imports. Raises the domestic price, reduces import quantity, protects domestic producers and costs consumers more than producers gain — the deadweight loss.
Quota
A quantity limit on imports. Similar price effects to a tariff, but the revenue goes to whoever holds the import license rather than to the government.
Capital flows and growth
Foreign investment adds to the domestic capital stock and can raise LRAS. The cost is that future returns on that capital accrue abroad.
Purchasing power parity
The long-run tendency for exchange rates to move so identical goods cost the same across countries. A country with persistently higher inflation should see its currency depreciate.
Why an appreciation weakens expansionary fiscal policy
Deficit spending raises the real interest rate, attracting capital and appreciating the currency, which cuts net exports — crowding out working through trade rather than investment.
The balance of payments identity
Current account + financial account ≈ 0. A country importing more than it exports must pay with assets, and that asset sale IS the financial account surplus.
What a trade deficit actually is
Foreigners holding surplus dollars can only spend them on dollar assets, so they buy bonds, shares and firms. The deficit and the capital inflow are one event.
Classifying a transaction
Did a good, service or income flow cross the border (current account) or did an asset change owners (financial account)? Then: money in (credit) or out (debit)?
Tourism is a service
A holiday abroad is a service import and belongs in the current account, not the financial account, even though money left the country.
Investment income is current account
Dividends and interest received on assets already owned abroad are INCOME, so current account. Buying the asset in the first place was financial account.
When a current account deficit is a problem
When the incoming capital funds consumption. When it funds productive investment, future output can service the obligation. The exam wants that distinction, not a verdict.
A forex graph is for ONE currency
Horizontal: quantity of that currency. Vertical: its price in another currency. Draw the market for dollars and the axis reads euros per dollar.
The mirror rule
Dollar appreciates ⇔ euro depreciates. Demand for dollars up ⇔ supply of euros up. One transaction, two graphs — never both shifts on one diagram.
What shifts currency demand
Foreigners wanting exports, wanting domestic assets (so a higher domestic rate), or wanting the currency for travel or speculation.
What shifts currency supply
Residents wanting imports, wanting foreign assets (so a higher foreign rate), or traveling abroad.
Who gains from appreciation
Consumers of imports gain; exporters lose. Depreciation reverses it. Net exports fall on appreciation and rise on depreciation.
Why the exchange rate reinforces monetary policy
A rate cut sends capital out, depreciating the currency and raising net exports — which ADDS to the investment channel rather than opposing it.
International crowding out
Fiscal expansion raises the rate, attracts capital, appreciates the currency and cuts net exports. A second offset alongside domestic crowding out.
Why the differential matters, not the level
Capital responds to the gap between two countries' returns. Equal cuts in both countries leave the differential unchanged and the exchange rate need not move.
Capital chases the REAL return
A 10% nominal rate with 8% inflation beats nothing — 2% real is worse than 4% nominal with 1% inflation. Compute real rates before deciding the flow.
A capital inflow shifts loanable funds SUPPLY
Foreign investors are lenders, so they add to the pool. Supply right, domestic real rate down, investment up.
The cost of foreign-financed investment
Future interest, dividends and profits flow abroad as current account debits, and a sudden withdrawal spikes rates and the exchange rate.
The four-graph order
AD–AS for output and prices, money market for the nominal rate, loanable funds for the real rate and investment, forex for the exchange rate and net exports.
The consistency checks
GDP up ⇒ unemployment down, money demand up, nominal rate up. Real rate up ⇒ investment down, capital in, currency appreciates, Xn down.
The two inconsistencies students write
Output up with the interest rate falling (a demand expansion cannot do that), and appreciation with net exports rising (which reverses the definition).
Exports and imports in GDP
Xn = exports − imports. Imports are subtracted because they were counted in C, I or G but produced abroad — the subtraction removes foreign production, not domestic demand.
Why a strong currency is not simply good
It raises purchasing power over imports and lowers export competitiveness. Consumers gain and exporters lose, so "strong" describes a price, not a verdict.
Fixed vs floating exchange rates
Floating rates are set by supply and demand. A fixed rate requires the central bank to buy or sell its own currency using reserves to defend the peg.
How a central bank defends a peg
It buys its own currency with foreign reserves to prevent depreciation, or sells its own currency to prevent appreciation. Reserves are finite, which is why pegs break.
Purchasing power parity in one sentence
Exchange rates should adjust so identical goods cost the same everywhere, so persistently higher inflation should mean a persistently depreciating currency.
Why the J-curve exists
After a depreciation, contracted trade volumes take time to respond, so the trade balance can worsen before it improves. Quantities adjust more slowly than prices.
Tariffs and the exchange rate
A tariff cuts imports, reducing the supply of domestic currency abroad, which appreciates it — partly offsetting the tariff's protective effect on exporters.
Net exports as an AD component
Xn shifts AD, so anything that moves the exchange rate moves aggregate demand. This is the channel that links Unit 6 back to Unit 3.
Why the current account cannot be read alone
It is the mirror of the financial account. A policy that improves one necessarily worsens the other, so a goal of "reducing the trade deficit while attracting investment" is incoherent.
Capital flight
A sudden withdrawal of foreign capital. The currency depreciates sharply and interest rates spike, which is why foreign-financed growth carries risk as well as benefit.

What examiners penalize here

Practice Macro

Our practice bank is drawn from across the whole course rather than filtered to one unit, which is closer to how the exam asks anyway — it will not tell you which unit a question is testing.

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Questions about this unit

How much of the AP Macroeconomics exam is Unit 6?

Unit 6, Open Economy, is worth 10–13% of the Macro multiple-choice section according to the published course framework. Across all 6 units that makes it a substantial share — heavier than an even split would give it.

What topics are covered in Macro Unit 6?

Open Economy covers Balance of payments, Exchange rates, Trade and Capital flows. We publish 52 terms with definitions for this unit, all of them on this page.

How should I study Macro Unit 6?

Read the 8 lessons below first — about 110 minutes — then drill the 52 terms in cram mode until you can produce each definition from memory rather than just recognize it. Recognition is what makes a unit feel finished when it is not. Finish with practice questions and read the explanation for every one you get right by elimination as well as the ones you miss.

All 6 units of AP Macroeconomics

  1. Unit 1 · Basic Economic Concepts
  2. Unit 2 · Economic Indicators & Business Cycle
  3. Unit 3 · National Income & Price Determination
  4. Unit 4 · Financial Sector
  5. Unit 5 · Long-Run Consequences of Policy
  6. Unit 6 · Open Economy

Unit names, topics and exam weights follow the published College Board course framework for AP Macroeconomics. AP® is a trademark registered by the College Board, which does not endorse this site.