Download Problem Set 3 Answers Part 1

Economics of Exchange Rate Policy & Balance of Payments
1. Assume there are two countries, US and Mexico. Assume that the US has a
flexible exchange rate policy. Draw the supply and demand curves for the Peso
and the dollar, with $ per peso on the y axis and number of Mexican pesos on the
x axis. The demand curve for pesos is as follows:
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If pesos cost 1 dollar, Americans want 400 pesos
If pesos cost 2 dollars, Americans want 300 pesos
If pesos cost 4 dollars, Americans want 100 pesos
The supply curve for pesos is as follows:
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If pesos cost 1 dollar, Mexicans and others are willing to “sell” 100 pesos
If pesos cost 2 dollars, Mexicans and others are willing to “sell” 200 pesos
If pesos cost 4 dollars, Mexicans and others are willing to “sell” 400 pesos
Flexible Exchange Rate Graph Dollars per Peso 6 5 4 3 Supply Curve for Pesos 2 Demand Curve for Pesos New Demand Curve 1 0 100 200 300 400 500 Pesos (Quantity) a. Under a floating exchange rate system, what will supply and demand
determine the price of dollars per peso to be? How many Mexican pesos
will the US exchange?
The price of dollars per peso is located at the point where the supply
and demand curves intersect. This will occur when x = 250 pesos and
y = 2.50 dollars per peso. Thus, the exchange rate will be $2.50 USD
per peso. These details are illustrated graphically above.
b. Now assume that Mexico discovers more oil, resulting in increased
exports from Mexico to the US, and increased investment flows from the
US to Mexico. Draw a new peso demand line reflecting this change. What
effect will this have on the balance of payments between the US and
Mexico? What effect will this have on the exchange rate, the price of
dollars per peso (i.e., did the exchange rate increase or decrease)? Did the
dollar appreciate or depreciate?
The increased Mexican exports and investment flows from the US to
Mexico entail an increase in the demand for pesos. As a result, a new
demand curve should be drawn to the right of the previous one,
indicating an increase in the demand for pesos at any given price.
This line appears in green in the above graph. The increase in exports
and inward investment to Mexico will improve Mexico’s balance of
payments (that is, Mexico will tend toward having a balance of
payments surplus). The price of dollars per peso will increase because
there is relatively greater demand for pesos at any given price. This
means that the USD depreciated relative to the peso.
c. After the exchange rate adjusts, how would the new exchange rate affect
trade in the future? What would this do to the balance of payments over
time?
The new exchange rate means that Mexican goods are increasingly
expensive for US consumers. As a result, Mexico will export fewer
goods to the US. This will help the US balance of payments over time
(that is, it will move back toward having a balance of payments
surplus).
2. Now assume a fixed exchange rate – that is, the US has a policy that the official
exchange rate will remain what it was in Part 1A, even if supply and demand
changes.
a. Redraw the supply and demand curves for pesos and dollars (hint: this
graph will look identical to Part 1A above).
This graph is identical to initial supply and demand graph that
appears above.
b. Again, assume that Mexico discovers more oil. Draw a new peso demand
line reflecting this change. How will this affect the balance of payments
and the exchange rate, and how is this different than what we would
observe under a flexible exchange rate system?
The new demand curve for pesos is the same as before. However,
rather than let the peso appreciate, the US will alter the money supply
to prevent changes in the exchange rate. In particular, the US can sell
its own reserves of pesos for US dollars. This will result in a depletion
of the foreign currency holdings of the US government. If the pesos
were invested in Mexico, increased capital inflows to Mexico would
reduce the balance of payments deficit of the US. A second option to
maintain the peg would be to raise the interest rate on US government
bonds, which would increase the supply of pesos (as peso holders
trade pesos for dollars to invest in the US) and increase capital inflows
to the US, also reducing the balance of payments deficit of the US. A
third option would be for the US to impose capital controls that
prevent US dollars from leaving the country. This will increase the
black market price of dollars (the official exchange rate would remain
the same). The increase in import expenditures would depend on how
many pesos could be acquired through black market currency
exchanges.
Overall, the official exchange rate will remain the same, which is
different than what we observe under the flexible system (under
which the official exchange rate shifts), and the effect of the demand
shift will be felt in other ways, such reducing foreign currency
reserves, or increasing US interest rates (loss of monetary policy) or
creating a black market premium.
c. After the initial changes, what will be the effect on the exchange rate over
time? What will be the effect on the balance of payments over time?
After the initial changes, the exchange rate should remain the same.
However, it is possible that the US will run out of foreign currency
(specificaily, peso) reserves, in which case the fixed exchange rate
becomes unsustainable.
d. BONUS QUESTION: What other effects might the fixed exchange rate
policy have on the economy (positive or negative)?
One advantage of a fixed exchange rate is that it reassures traders and investors
(reduces currency risk) if it is credible, thus helping the economy. If it is not
credible, however, it will encourage speculation which is destabilizing. If capital
controls are employed to maintain the fixed exchange rate, it could also result in
black market inefficiencies, which would hurt