Download International Trade and Finance: Exchange Rate Policy

International Trade
and Finance:
Exchange Rate Policy
AP Economics
Mr. Bordelon
Exchange Rate Regimes
• Nominal exchange rate is a price that is determined by
free market forces of supply and demand.
• Countries can deliberately manipulate the exchange
rate of its own currency to achieve certain economic
goals.
• Why would a country do this? Because the exchange
rate has a great deal of influence on net exports.
• If your nation’s currency is inexpensive, foreigners
will find your goods to be inexpensive and your net
exports will rise.
Exchange Rate Regimes
• Exchange rate regime. Rule governing
policy toward the exchange rate.
• Fixed exchange rate. When the government
keeps the exchange rate against some other
currency at or near a particular target.
• Example. Hong Kong has an official policy of
setting an exchange rate of HK$7.80 per $1.
• Floating exchange rate. When the
government lets the exchange rate go wherever
the market takes it.
• Example. U.S., U.K., Canada.
Exchange Rate Regimes
• If exchange rates are determined by the free
market, then how can an exchange rate be fixed?
• Exchange market intervention. Government
purchases or sales of currency in the foreign
exchange market.
• Foreign exchange reserves. Stocks of foreign
currency that governments maintain to buy their
own currency on the foreign exchange market.
Exchange Rate Regimes
Example. Princess Hathaway from Genovia has decided to fix the Genovian
geno equal to $1.50. Unfortunately for Genovia, $1.50 is not the equilibrium
XR. The graphs above show what happens when the geno is fixed at $1.50
where there is a shortage or surplus of genos.
In (a), there is a surplus of genos in the foreign exchange market. This would
normally push the value of the geno down (how do you get rid of a surplus?).
What Genovia is trying to do is prevent a depreciation of the geno against the
dollar.
There are three actions Genovia could take to prevent the depreciation.
1. Buy its own currency in the foreign exchange market. In other words,
an exchange market intervention. To do this, the Genovian government must
have enough U.S. dollars in foreign exchange reserves to exchange for genos.
What’s happening is that the governments are using foreign currency to buy
their own currency to support the price level. Applied here, Genovia is buying
genos with its foreign exchange reserves of U.S. dollars to increase the geno’s
value against the dollar.
Governments and central banks sell foreign assets for this reason. This is
how they support their currency through exchange market intervention.
2. Attempt to affect market supply and demand so that the price rises to
the fixed rate. In other words, it’s time to play Wheel of Monetary Policy!
For example, to support the geno, the central bank can raise the Genovian
interest rate. This increases capital into Genovia, increasing demand for
genos. It reduces capital flows out of Genovia, reducing genos supply.
Key point: An increase in a country’s interest rate will increase the value of
its currency.
3. Reduce supply of genos to foreign exchange market. Typically, this is
done by restricting residents’ right to buy foreign currency.
Foreign exchange controls. Licensing systems that limits the right of
individuals to buy foreign currency.
Key point: Foreign exchange controls increase the value of a country’s
currency.
The focus up to this point has been on preventing depreciation of the currency
to equilibrium. Looking at it when equilibrium is above the target exchange
rate, we can use the same policies just discussed, but reversed.
Exchange market intervention. Selling genos and acquiring U.S. dollars,
which it adds to its foreign exchange reserves.
Monetary policy bingo. Genovia can reduce interest rates to increase supply
of genos and reduce demand.
Foreign exchange restrictions. Limit ability of foreigners to buy genos.
Advantages and Disadvantages of
Exchange Rate Regimes
• Advantages
• Stability. Fixed exchange rate provides
stability in foreign transactions in the same way
Americans conduct transactions across state
lines.
• Example. If Katie takes her dollars from Florida to
Georgia, she knows that the value of her dollars is
unchanged. But if she takes her dollars from Florida
to Europe, the value of those dollars can change
daily. Fixed exchange rates avoids this uncertainty.
Advantages and Disadvantages of
Exchange Rate Regimes
• Advantages
• Fixed exchange rate also “commits” central
banks to monetary policies that would not upset
the exchange rate.
• Example. If central bank adhered to the exchange
rate regime, central bank could not increase MS.
This would cause inflation and reduce the value of
the currency. In other words, more stability.
Advantages and Disadvantages of
Fixed Exchange Rate Regimes
• Disadvantages
• To stabilize an exchange rate through
intervention, a country must keep large
quantities of foreign currency on hand, and that
currency is usually a low-return investment.
• Large reserves can be exhausted when there are
large capital flows out of a country.
Advantages and Disadvantages of
Fixed Exchange Rate Regimes
• Disadvantages
• If a country chooses to stabilize an exchange
rate by adjusting monetary policy rather than
through intervention, it must divert monetary
policy from other goals, notably stabilizing the
economy and managing the inflation rate.
• Foreign exchange controls distort incentives for
importing and exporting g/s.
• Bureaucracy and corruption.
Question 1
Suppose the United States and China were the only two countries in the world.
a.
Draw a correctly labeled graph of the foreign exchange market for U.S.
dollars showing the equilibrium in the market. The currency in China is the
yuan.
b.
On your graph, indicate a fixed exchange rate set below the equilibrium
exchange rate. Does the fixed exchange rate lead to a surplus or shortage of
U.S. dollars? Explain and show the amount of the surplus/shortage on your
graph.
c.
To bring the foreign exchange market back to an equilibrium at the fixed
exchange rate, would the U.S. government need to buy or sell dollars? On
your graph, illustrate how the government buying or selling dollars would
bring the equilibrium exchange rate back to the desired fixed rate.
d.
Suppose that instead of buying or selling dollars, the Federal Reserve was
going to engage in monetary policy to bring the foreign exchange market
back to an equilibrium at the fixed exchange rate. Should the Fed buy or sell
Treasury securities in an open-market operation? Explain.