AP Syllabus focus: ‘Changes in currency demand and supply in the foreign exchange market change the equilibrium exchange rate.’
These notes explain how shifts in currency demand and currency supply alter the market-clearing exchange rate. You will learn how to read the standard graph, predict the direction of change, and describe the adjustment process.
Core idea: equilibrium moves when curves shift
In the foreign exchange market, the exchange rate is determined by the interaction of demand for a currency and supply of a currency. If either curve shifts, the market reaches a new equilibrium with a different exchange rate (and usually a different quantity of currency exchanged).
Key terms used on AP graphs
Equilibrium exchange rate: The exchange rate at which the quantity of a currency demanded equals the quantity of that currency supplied.
On the typical graph:
Supply and demand in the foreign exchange market determine the equilibrium exchange rate at the intersection of the two curves. The figure also shows the “inverse-quote” perspective (pricing the other currency), reinforcing that exchange rates can be expressed either way while still clearing the same market. Source
The vertical axis is the exchange rate (the “price” of the currency).
The horizontal axis is the quantity of the currency exchanged.
Demand (D) slopes downward; Supply (S) slopes upward.
The intersection of D and S gives the equilibrium exchange rate and equilibrium quantity.
A shift means the entire curve moves left or right (not movement along a curve).
How a demand shift changes the exchange rate
A shift in demand changes equilibrium by changing how much of the currency buyers want at each exchange rate.
Increase in demand for a currency (D shifts right)
When demand increases:
The equilibrium exchange rate rises
The equilibrium quantity of currency exchanged rises
Interpretation: the currency becomes more expensive in terms of the other currency.
Mechanically on the graph:
At the original exchange rate, quantity demanded exceeds quantity supplied (a shortage of the currency).
Buyers bid up the currency’s price, moving up along S until the new intersection is reached.
Decrease in demand for a currency (D shifts left)
When demand decreases:
The equilibrium exchange rate falls
The equilibrium quantity of currency exchanged falls
Mechanically:
At the original exchange rate, quantity supplied exceeds quantity demanded (a surplus of the currency).
Sellers accept a lower price, moving down along S to the new intersection.
How a supply shift changes the exchange rate
A shift in supply changes equilibrium by changing how much of the currency sellers provide at each exchange rate.
Increase in supply of a currency (S shifts right)
When supply increases:
The equilibrium exchange rate falls
The equilibrium quantity of currency exchanged rises
Mechanically:
At the original exchange rate, there is a surplus of the currency.
The exchange rate is pushed down until quantity demanded equals quantity supplied again.
Decrease in supply of a currency (S shifts left)
When supply decreases:
The equilibrium exchange rate rises
The equilibrium quantity of currency exchanged falls
Mechanically:
At the original exchange rate, there is a shortage of the currency.
The exchange rate rises until the shortage disappears at the new equilibrium.
Quick direction guide (no causes—just effects)
Use this as a pure “shift → outcome” tool:
D right → exchange rate up, quantity up
D left → exchange rate down, quantity down
S right → exchange rate down, quantity up
S left → exchange rate up, quantity down
Describing adjustment precisely (AP writing)
The diagram shows the market moving from an initial equilibrium to a new equilibrium after shifts in demand and supply, with the exchange rate adjusting to eliminate the disequilibrium. It is especially useful for explaining why the exchange rate can move strongly even when both curves shift, and for practicing consistent “shift → shortage/surplus → price change → new equilibrium” narration. Source
When explaining an exchange-rate change, use the same structure every time:
Identify which curve shifts (D or S) and direction
State the disequilibrium at the old exchange rate (shortage or surplus)
State how the exchange rate changes (rises/falls) to restore equilibrium
State what happens to equilibrium quantity (rises/falls)
Clarity tip: always describe the exchange rate as the price of the currency on the graph; then “up” means the currency is more expensive, and “down” means it is cheaper.
FAQ
Use the currency being bought/sold in that market. The vertical axis is the price of that currency in terms of another (the quote currency), consistent with the problem’s quotation.
Yes. Determine the new equilibrium by combining shifts. The exchange rate direction can be ambiguous, but the quantity effect is clearer when both shifts move quantity the same way.
Because equilibrium is an intersection. Moving D or S typically changes both coordinates of that intersection, altering both the “price” and the market-clearing amount traded.
A shift changes demand or supply at every exchange rate (new curve). Movement along a curve is a response to a change in the exchange rate itself (same curve).
Rewrite the quote to match the graph’s “price of the currency.” If the graph prices dollars in yen, a rise means more yen per dollar; if it prices yen in dollars, the numerical change is inverted.
Practice Questions
(2 marks) In the market for the euro, the demand curve shifts right. State what happens to (i) the equilibrium exchange rate and (ii) the equilibrium quantity of euros exchanged.
Equilibrium exchange rate rises (1)
Equilibrium quantity of euros exchanged rises (1)
(5 marks) Using a demand-and-supply diagram for a currency, explain how a leftward shift of the supply curve changes the equilibrium exchange rate. In your explanation, refer to the initial disequilibrium and the adjustment process.
Shows/states supply shifts left (1)
Identifies shortage at the initial exchange rate (1)
Explains exchange rate is bid up/rises to remove shortage (1)
States new equilibrium occurs where D = S again (1)
States equilibrium quantity exchanged falls (1)
