Reading the Forex Graph Without Getting Lost

You’ll be able to

Label a foreign exchange diagram for a specified currency
Translate a statement about one currency into the mirror statement about the other
Predict the effect of a demand or supply shift on the exchange rate

The graph is for ONE currency

Every forex diagram is the market for a single named currency. The horizontal axis is the quantity of that currency; the vertical axis is its price in terms of another currency. Draw the market for dollars and the vertical axis reads euros per dollar. Draw the market for euros and it reads dollars per euro. These are reciprocal axes, so the same event appears as a rise on one graph and a fall on the other. Most lost points in this unit come from drawing the market for one currency while reasoning about the other.

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.

What shifts demand and supply

Demand for a currency rises when foreigners want more of what that currency buys: its exports, its assets (so a higher domestic interest rate), or the currency itself for speculation or tourism. Supply of a currency rises when its own residents want foreign things: imports, foreign assets (so a higher foreign interest rate), or foreign travel. So a higher domestic interest rate raises demand for the domestic currency and it appreciates.

Appreciation and depreciation, and who gains

A currency appreciates when it buys more foreign currency. That makes the country's exports more expensive abroad and imports cheaper at home, so net exports fall. Depreciation does the reverse: exports cheaper, imports dearer, net exports rise. The distributional consequence is worth stating because questions ask it: appreciation helps consumers of imports and hurts exporters, while depreciation helps exporters and hurts import consumers.

Worked example

The United States raises interest rates while European rates are unchanged. Show the effect in the market for dollars and in the market for euros, and state the effect on United States net exports.

1.Higher United States rates make dollar assets more attractive, so demand for dollars shifts right.
2.In the market for dollars, the dollar appreciates — more euros per dollar.
3.The mirror: Europeans supply more euros to buy those dollars, so supply of euros shifts right and the euro depreciates.
4.A stronger dollar makes United States exports dearer abroad and imports cheaper at home.

Answer: The dollar appreciates and the euro depreciates — the same event on two graphs. United States net exports fall, which partly offsets the contractionary effect of the rate rise on AD.

Watch out

Do not shift both demand and supply on the same forex graph unless the question genuinely describes two separate changes. One transaction is a demand shift on one currency's graph and a supply shift on the other's — never both on the same diagram.

Checkpoint

On a graph of the market for Mexican pesos, the vertical axis measures:

Checkpoint

The Canadian dollar appreciates against the Japanese yen. It follows that:

Checkpoint

Domestic consumers sharply increase purchases of imported goods. In the market for the domestic currency:

On the exam

Write the currency name in the graph title — "Market for U.S. Dollars" — before drawing anything. It costs a second and prevents the single most expensive error in this unit.

Answer the 3 checkpoints as you read.