AP Syllabus focus: ‘Changes in demand for a country's goods, services, or assets shift currency demand, while trade barriers can shift currency supply.’
Understanding what shifts currency demand and supply helps you predict exchange rate movements. In AP Macroeconomics, focus on how trade, investment, and policy changes alter foreigners’ and residents’ currency transactions.
Core setup: why currency demand and supply exist
The foreign exchange market and the exchange rate
Foreign exchange market: The market in which currencies are bought and sold so that buyers can make international purchases of goods, services, and assets.
In this market, the exchange rate is the price of one currency in terms of another, and it changes when currency demand or currency supply shifts.
Demand for a currency: The desire to buy a currency to purchase that country’s goods, services, or financial assets.
A useful way to think: foreigners demand your currency when they want things priced in your currency (your exports, your assets).
Supply of a currency: The amount of a currency offered in exchange for other currencies, often to buy foreign goods, services, or assets.
A useful way to think: your residents supply your currency when they need foreign currency (imports, buying foreign assets, travelling abroad).
What shifts demand for a country’s currency (D)
The syllabus emphasises: changes in demand for a country’s goods, services, or assets shift currency demand. These are “demand-side” shocks because they change how much of the currency foreigners want to buy.
1) Changes in foreign tastes and preferences for domestic products
If foreign consumers develop stronger preferences for a country’s exports (branded goods, tech products, cultural products), they need more of that country’s currency to pay domestic sellers.
Result: currency demand shifts right.
2) Changes in foreign income (foreign business cycle)
When trading partners’ incomes rise, they typically buy more imports, including your exports.
Higher foreign income tends to raise demand for your goods and services, increasing demand for your currency.
3) Changes in relative rates of return on financial assets
This figure shows the foreign exchange market for a currency when its relative return rises (e.g., higher domestic interest rates). Demand for the currency shifts right (foreigners want more of the currency to buy higher-yielding assets) while supply shifts left (holders are less willing to trade it away). The new equilibrium occurs at a higher exchange rate, illustrating currency appreciation. Source
Foreign investors must buy your currency to purchase domestic financial assets (stocks, bonds, real estate).
If domestic assets become more attractive (higher perceived return, lower risk, improved growth outlook), foreigners increase purchases.
Result: currency demand shifts right.
If domestic assets become less attractive (greater perceived risk, political instability, weaker expected performance), demand can shift left.
4) Changes in expectations (forward-looking behaviour)
This figure illustrates how expectations alone can move exchange rates: if market participants expect a currency to appreciate, they demand more of it now, shifting demand right. At the same time, current holders supply less of it (they prefer to hold it), shifting supply left. The combined shifts raise the exchange rate immediately, showing how expectations can be self-reinforcing. Source
Even without immediate changes in trade or interest rates, expectations can move demand:
If investors expect a currency to appreciate, holding assets denominated in that currency may look more profitable, raising demand now.
If investors expect depreciation, they may reduce holdings, lowering demand.
What shifts supply of a country’s currency (S)
The syllabus highlights that trade barriers can shift currency supply. Supply shifts when domestic residents change how much of their currency they exchange to obtain foreign currency.
1) Changes in domestic demand for imports
When domestic consumers and firms buy more imports, they must sell (supply) domestic currency to get foreign currency.
Higher import spending: currency supply shifts right.
This diagram links trade flows to the FX market by showing that increased import spending increases the supply of the domestic currency in foreign exchange markets. The supply curve shifts right (more domestic currency is sold to obtain foreign currency), lowering the equilibrium exchange rate. It’s a concrete visual for why higher imports tend to put downward pressure on a currency. Source
Lower import spending: currency supply shifts left.
2) Trade barriers (tariffs, quotas, and related restrictions)
Trade barriers directly affect imports, so they are a key AP driver of currency supply shifts.
Tariffs raise the domestic price of imports; quotas limit import quantities.
If imports fall, residents need less foreign currency.
Result: currency supply shifts left (fewer units of domestic currency are exchanged for foreign currency).
3) Domestic tastes for foreign goods, services, and travel
A surge in demand for foreign brands, streaming/subscriptions priced abroad, or international tourism increases the need for foreign currency.
Result: currency supply shifts right.
4) Domestic purchases of foreign assets
If domestic investors increase purchases of foreign bonds/stocks/real estate, they supply more domestic currency to buy foreign currency.
Result: currency supply shifts right.
If domestic investors “repatriate” funds and reduce foreign asset purchases, supply can shift left.
FAQ
No. The effect depends on how strongly import quantities respond to higher prices and whether firms switch to untaxed supplier countries.
Key influences include:
price elasticity of demand for imports
availability of domestic substitutes
size of the imported share of consumption
They can change currency transactions even without trade in goods. If foreigners send transfers to residents, they may need to buy the recipient country’s currency, raising currency demand. If residents send transfers abroad, they supply more domestic currency.
Investors care about risk-adjusted returns. If default risk, political instability, or capital controls become more likely, foreign buyers may avoid the country’s assets, shifting currency demand left despite unchanged nominal yields.
Inbound tourism raises currency demand because foreign visitors exchange their currency to buy domestic services. Outbound tourism raises currency supply because residents exchange domestic currency to buy foreign services abroad.
Indirectly, yes. If trade barriers trigger retaliation that reduces exports or harms domestic income, residents might buy fewer domestic assets and more foreign assets, raising currency supply through financial outflows.
Practice Questions
Question 1 (3 marks) State two changes that would increase demand for a country’s currency in the foreign exchange market, and explain briefly why each would increase demand.
1 mark: Identifies a valid demand shifter linked to goods/services/assets (e.g., higher foreign income; stronger foreign preference for exports; higher attractiveness of domestic assets; expectations of appreciation).
1 mark: Explains first shifter increases foreigners’ need to buy the currency (to purchase exports or assets).
1 mark: Explains second shifter increases foreigners’ need to buy the currency (to purchase exports or assets).
Question 2 (6 marks) A country introduces a tariff that reduces its imports. At the same time, foreign investors become more willing to buy this country’s government bonds. Using demand and supply for the currency, explain how each change affects (i) currency supply and/or demand and (ii) the value of the currency.
1 mark: Tariff reduces imports.
1 mark: Reduced imports decrease currency supply (shift left).
1 mark: Leftward supply shift increases the currency’s value (appreciation).
1 mark: Foreign investors buying bonds increases currency demand (shift right).
1 mark: Rightward demand shift increases the currency’s value (appreciation).
1 mark: Clear linkage to buying currency for goods/services/assets (transactions-based explanation).
