MODULE 43 EXCHANGE RATE POLICY

MODULE 43 ESSENTIAL QUESTIONS

1. What is the difference between fixed exchange rates and floating exchange rates?

2. How do countries choose different exchange rate regimes? What considerations are taken into account?

EXCHANGE RATE POLICY

1. Nominal Exchange Rates: determined by s____________& d_________

2. G______________ have more power to influence nominal exchange rates than prices.

3. Exchange rates are important to countries where exports and imports are a large portion of _______.

4. Can a nation deliberately manipulate the exchange rate of its own currency to achieve certain economic goals? Why would the government do this?

EXCHANGE RATE POLICY

1. Nominal Exchange Rates: determined by supply & demand

2. Governments have more power to influence nominal exchange rates than other prices.

3. Exchange rates are important to countries where exports and imports are a large portion of GDP.

4. Can a nation deliberately manipulate the exchange rate of its own currency to achieve certain economic goals? Why would the government do this?

EXCHANGE RATE REGIMES

1. Exchange Rate Regime:

2. Fixed Exchange Rate:

3. Example: Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$1.

4. http://www.youtube.com/watch?v=XnAT7FZpmg0&safety_mode=true&persist_safety_mode=1&safe=active

5. Floating Exchange Rate:

6. Examples:

7. "Managed" & "Target Zone"

EXCHANGE RATE REGIMES1. Exchange Rate Regime: rule governing policy toward the exchange rate.

2. Fixed Exchange Rate: keeps the exchange rate against some other currency at or near a particular target.

3. Example: Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$1.

4. http://www.youtube.com/watch?v=XnAT7FZpmg0&safety_mode=true&persist_safety_mode=1&safe=active

5. Floating Exchange Rate: government lets the exchange rate go wherever the market takes it

6. Examples: Britain, Canada, and the United States

7. "Managed" & "Target Zone"

HOW CAN AN EXCHANGE RATE BE HELD FIXED? (EX. CHINA)

Exchange Market Intervention

Foreign Exchange Reserves

Foreign Exchange Controls

HOW CAN AN EXCHANGE RATE BE HELD FIXED?

Exchange Market Intervention

Buy up the surplus of Yuan in the foreign exchange market.

Governments keep foreign exchange

reserves, or stocks of foreign currencies, so that they can do just

this.

Foreign Exchange Reserves

Shift either the demand or supply curves so that the exchange price rises.

Chinese policymakers can increase interest

rates to attract foreign capital investment,

increasing the demand for the Yuan, reducing

the capital outflow from China, reducing the

supply of Yuan, and the price of the Yuan will

begin to rise.

Foreign Exchange Controls

The government can limit the right of

individuals to buy foreign currency. (must have a license purchase dollars, thus reducing

the supply of the yuan.) The price will begin to

rise.

China fixes their currency, the Yuan, at a rate of $1 US for every 6 Yuan.

If the Yuan is exchanged in a free market, the equilibrium exchange rate may be higher, or lower, than the target rate of $1 (which is what they are afraid of)

What can the government of China do to get equilibrium where they want it?

1. Buy up the surplus of Yuan in the foreign exchange market (exchange market intervention.) Governments keep foreign exchange reserves, or stocks of foreign currencies, so that they can do just this.

2. Shift either the demand or supply curves so that the price rises to the target of $1. Chinese policymakers can increase interest rates to attract foreign capital investment, increasing the demand for the yuan, reducing the capital outflow from China, reducing the supply of yuan, and the price of the Yuan will begin to rise.

3. The government can limit the right of individuals to buy foreign currency. (must have a license purchase dollars, thus reducing the supply of the yuan.) The price will begin to rise.

What can the government of China do to get equilibrium down where they want it?

4. Sell yuan in the foreign exchange market. 5. Chinese policymakers can decrease interest rates. This will decrease foreign

capital investment, decreasing the demand for the yuan. This will also increase the capital outflow from China, increasing the supply of yuan. The price of the yuan will begin to fall.

6. The government can limit the ability of foreigners to buy the yuan. The price will begin to fall.

But is it actually a good idea to fix the exchange rate?

THE EXCHANGE RATE REGIME DILEMMA: PRO•The Case for Fixed Exchange Rates

• Facilitates trade by creating certainty about the exchange rate

• Acts as a check on inflationary policies:

• The bank adheres to the exchange rate regime, so they cannot dramatically increase the money supply.

• If they did, this would cause inflation & reduce the value of the currency. (more stability)

THE EXCHANGE RATE REGIME DILEMMA: CON

The Case against Fixed Exchange Rates: The costs

• Requires large foreign currency reserves that may not be profitable

• May divert monetary policy from managing the inflation rate

• Distorts incentives for importing & exporting goods and services (because it is artificial)

• Opportunity for red tape & corruption

• http://www.youtube.com/watch?v=T1dDIrOCbUo&feature=fvwrel&safety_mode=true&persist_safety_mode=1&safe=active

Module Review Questions p. 435-436

Read Module 44 p. 437-441