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Exchange$ Problem #1 Answers (
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points)
Open the Exchange$ module. Make note of the initial equilibrium conditions and
graph.
1)
First write a brief discussion of the effect you expect changes in domestic real
GDP to have on the exchange rate between the dollar and the Euro and on
the number of dollars exchanged. Then change domestic real GDP to $12
trillion.
An increase in domestic GDP should increase domestic demand for foreign goods. As a
result the supply of dollars to the market (equivalent to the demand for Euros when that is
the only other currency) should increase. This shift in supply of dollars should reduce the
price of the dollar in terms of Euros, which is how the exchange rate is measured in this
module. The shift should also increase the quantity of dollars traded in the market.
Examine the new market equilibrium and explain why one of the functions
shifted. Explain why the shift in that function caused the given change in the
exchange rate and in the number of dollars exchanged.
The supply of dollars shifted outward because of the increase in US income and the
consequent demand for foreign goods. The foreign goods must be bought with Euros and
dollars must be sold to buy the Euros. At the original price of dollars there is now a
surplus of dollars on the market. The Law of Supply and Demand (Law of Markets)
works in this market as in other competitive markets, so when there is a surplus the price
falls, increasing quantity demanded and reducing quantity supplied. The process should
continue until the change in price eliminates the surplus.
Price
Quantity
Initial
€ 1.00
100.00
Domestic GDP = $12
€ 0.90
104.00
If these results differ from those you expected, explain the difference and
state whether the results you observe in the module are more realistic that
those you expected, or less realistic.
The results are as expected.
2)
Now write a brief discussion of the effect you expect foreign real GDP to have
on the exchange rate between the dollar and the Euro and on the number of
dollars exchanged. Then change the foreign real GDP to $8 trillion.
A decrease in foreign GDP should reduce foreign demand for domestic goods. As a
result the demand for dollars in the market (equivalent to the supply for Euros when that
is the only other currency) should decrease. This shift in demand for dollars should
reduce the price of the dollar in terms of Euros, which is how the exchange rate is
measured in this module. The shift should also reduce the quantity of dollars traded in
the market.
Examine the new market equilibrium and explain why one of the functions
shifted. Explain why the shift in that function caused the given change in the
exchange rate and in the number of dollars exchanged.
The demand for dollars shifted inward because of the fall in foreign income and the
consequent decrease in demand for US goods. The US goods must be bought with
dollars and Euros must be sold to buy the dollars. At the original price of dollars there is
now a surplus of dollars on the market. The Law of Supply and Demand (Law of
Markets) works in this market as in other competitive markets, so when there is a surplus
the price falls, increasing quantity demanded and reducing quantity supplied. The
process should continue until the change in price eliminates the surplus.
Price
Quantity
Initial
€ 1.00
100.00
Foreign GDP = $8
€ 0.92
95.20
If these results differ from those you expected, explain the difference and
state whether the results you observe in the module are more realistic that
those you predicted, or less realistic.
The results are as expected.
3)
Now, explain the similarities and differences in your results in (1) and (2).
Emphasize the directions of change in the exchange rate and in the quantity
exchanged rather than the amounts of change in your discussion.
Both changes resulted in a lower value for the dollar in the exchange market. The
changes both caused surpluses and price always declines in the event of a surplus.
However, the quantity exchanged is reduced when demand for dollars decrease and the
quantity exchanged increases when supply increases.
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4)
Re-start the module and proceed to the option to regulate the market. (This
procedure re-sets the equilibrium to the original value.) Impose a rate of
€0.90, below the equilibrium exchange rate. Compare the effects of having
the exchange rate fixed at $1 equal to €0.9 with the results of letting the
market set the exchange rate at $1 = €1. Explain why the U.S. would end up
with added reserves with the lower exchange rate that you set.
With Regulation
Fixed Rate
Private Supply
Private Demand
Added Reserves
Total Reserves
% of Real GDP
Without Regulation
€ 0.90 Equilibrium Rate
€ 1.00
$ 94.00 Equilibrium
$ 100.00
Quantity
$ 104.00
€ 11.11
€ 84.11
0.10%
Setting an exchange rate of €0.90 = $1.00 causes an excess demand for dollars to exist at
the fixed price. In order to keep the price at this level the US would have to sell enough
dollars to meet that excess demands. Selling dollars for Euros gives the US a larger
stockpile of Euros (received in exchange for those dollars). This increase in the US stock
of Euros is an increase in US international reserves.
Explain the cost to the US of setting such a rate. Would some people in the
U.S. gain from having this rate set? Explain. Would some people in the U.S.
lose from having this rate set? Explain. Who would gain or lose in Europe
as a result of setting this fixed exchange rate? Explain.
With this fixed rate the US is selling its products to foreigners for low prices and is
accumulating large amounts of foreign money that give the country no real benefit. US
exporters gain (owners and workers) from getting larger sales in the foreign market.
Those who work in or own shares in import competing industries will gain since the
goods they compete against have become more expensive. Those in import using
industries are hurt because costs in those industries increase. The pattern of gains and
losses in Europe are the reverse of the pattern in the US. In Europe exporters lose some
of their US market, import competing industries face harder competition, and import
using industries get lower costs. The higher import costs in the US raises the price level
(not noted in the module itself) and that means some redistribution of wealth and income,
e.g., between creditors and debtors. The reverse happens in Europe. Both Europe and
the US lose overall because trade at non-equilibrium exchange rates causes a reduction in
overall economic efficiency (goods are being produced in the “wrong” places).
5)
Now change the regulation by imposing rate above equilibrium exchange
rate of €1.20. Compare the effects of having the exchange rate fixed at $1
equal to €0.9 with the results of letting the market set the exchange rate at $1
= €1.20.
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Price Ceiling
Fixed Rate
Private Supply
Private Demand
Added Reserves
Total Reserves
% of Real GDP
Price Floor
€ 0.90
$ 94.00
$ 104.00
€ 11.11
Fixed Rate
Private Demand
Private Supply
Government
Purchases
€ 84.11 Reserves
Remaining
0.10%
€ 1.20
$ 92.00
$ 112.00
$ 20.00
€ 56.33
Explain why the U.S. would lose reserves with this higher exchange rate.
How long could the U.S. continue to maintain this exchange rate, given that
these are the results after one year? What would happen at the end of that
period of time?
At the set exchange rate there is an excess supply of dollars in the private market. The
way the government can keep the exchange rate at this level is to buy up those excess
dollars, exchanging them for Euros out of the US stock of international reserves.
However, in the previous case the US was increasing its stockpile of Euros -- and could
do so indefinitely since the US government can never run short of dollars. In this case
the US is using up its stock of Euros, and cannot print up more. At the current exchange
rate the remaining stock of Euros (€56.33) is worth $46.94 (= €56.33/1.20) and, since the
government bought $20 in the first year the remaining reserves will last for $46.94/20 =
2.35 years. At the end of that time the US would not be able to continue maintaining this
rate, unless the Europeans gave the US a loan of Euros, or bought up the excess dollars
themselves. If the Europeans did not help out the exchange rate would have to be
allowed to move to the equilibrium, the excess supply of dollars would act on the market
(Laws of Supply and Demand) and the value of the dollar would fall to one Euro.
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