An exchange rate of $2 per pound means that anyone buying one British pound pays a price of $2. Moreover, every nation has currency exchange rates between their domestic currency and other countries. The United States has exchange rates, not only with British pounds, but Japanese yen, French francs, Mexican pesos, Canadian dollars, and a whole lot more.

Exchange rates surface as an aggregate demand determinant because they effect the relative prices of imports and exports, and thus the net exports component of aggregate expenditures. When exchange rates change, the relative prices of exports and imports also change, which causes exports, imports, net exports, and thus aggregate demand to change.

• An increase in the exchange rate, that is, the price of buying foreign currency in terms of domestic currency increases, causes an increase in net exports and an increase in aggregate demand.


• A decrease in the exchange rate, that is, the price of buying foreign currency in terms of domestic currency decreases, causes a decrease in net exports and a decrease in aggregate demand.

Shifting the Curve

Higher Exchange Rate

This higher exchange rate means that U.S. consumers pay more for any goods purchased from British producers (that is, imports). A British-made car selling for 10,000 British pounds in Britain costs U.S. consumers $20,000 at the original exchange rate and $25,000 at the new exchange rate. At this higher price, U.S. consumers are bound to buy fewer British-made products, causing imports to decline.

On the other side of the net export equation, British consumers pay less for goods purchased from U.S. producers (that is, exports). An American-made music CD selling for $20 in the United States costs British consumers 10 British pounds at the original exchange rate and 8 British pounds at the new exchange rate. At this lower price, British consumers are bound to buy more American-made products, causing exports to increase.

With imports falling and exports rising, net exports unquestionably increase. And with this increase in net exports goes an increase in aggregate demand. To see how an increase in the exchange rate of U.S. dollars for other currencies affects the aggregate demand curve, click the [Higher Rated] button. The higher exchange rates cause an increase in aggregate demand, which is a rightward shift of the aggregate demand curve.

Lower Exchange Rate

This lower exchange rate means that U.S. consumers pay less for any goods purchased from British producers (that is, imports). A British-made car selling for 10,000 British pounds in Britain cost U.S. consumers $20,000 at the original exchange rate and $15,000 at the new exchange rate. At this lower price, U.S. consumers are bound to buy more British-made products, causing imports to rise.

On the other side of the net export equation, British consumers pay more for goods purchased from U.S. producers (that is, exports). An American-made music CD selling for $20 in the United States cost British consumers 10 British pounds at the original exchange rate and 13.33 British pounds at the new exchange rate. At this higher price, British consumers are bound to buy fewer American-made products, causing exports to decline.

With imports rising and exports falling, net exports unquestionably decrease. And with this decrease in net exports goes a decrease in aggregate demand. To see how a decrease in the exchange rate of U.S. dollars for other currencies affects the aggregate demand curve, click the [Lower Rates] button. The lower exchange rates cause a decrease in aggregate demand, which is a leftward shift of the aggregate demand curve.

What Does It Mean?

Another possible reason for this lack of notoriety is that the powers-that-be in a country (that is, domestic producers) generally promote the higher exchange rate option to discourage imports and encourage exports. Producers face less competition from foreign products and export more production to other countries. The lower exchange rate option that would trigger the opposite result is seldom promoted. The higher exchange rate seems to be a "fact of life" and it is how the "world should be." No questions. No debate. But it is only one side of the possibilities.

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