insert e, ch 38 - chatham econ & us history [licensed for...

Chapter 38 - The Balance of Payments, Exchange Rates, and Trade Deficits

Chapter 38 The Balance of Payments, Exchange Rates, and Trade Deficits

QUESTIONS1. Do all international financial transactions necessarily involve exchanging one nation’s distinct currency for another? Explain. Could a nation that neither imports goods and services nor exports goods and services still engage in international financial transactions? LO1

Answer: The answer is almost certainly a yes. Only in rare cases would you find barter exchanges (goods and services for other goods and services). Yes, they could engage in financial transactions (the exchange of assets across countries).

2. Explain: “U.S. exports earn supplies of foreign currencies that Americans can use to finance imports.” Indicate whether each of the following creates a demand for or a supply of European euros in foreign exchange markets: LO1a. A U.S. airline firm purchases several Airbus planes assembled in France.b. A German automobile firm decides to build an assembly plant in South Carolina.c. A U.S. college student decides to spend a year studying at the Sorbonne in Paris.d. An Italian manufacturer ships machinery from one Italian port to another on a Liberian freighter.e. The U.S. economy grows faster than the French economy.f. A U.S. government bond held by a Spanish citizen matures, and the loan amount is paid back to that person.g. It is widely expected that the euro will depreciate in the near future.

Answer: American exports lead to an increase in the foreign-currency bank deposit holdings of Americans. These holdings will be decreased through American purchases of imports. Hence, the foreign-currency assets earned through exports can be used to finance imports.(a) A demand for euros: The U.S. airline must purchase euros before purchasing the Airbus planes. (b) A supply of euros: The German automobile firm must purchase U.S. dollars, or supply euros, before building the plant.(c) A demand for euros: The U.S. college student must purchase euros before studying in France.(d) A supply of euros: The Italian manufacturer must purchase U.S. dollars, or supply euros, to pay the Liberian freighter (which requires payment in U.S. dollars).(e) A demand for euros: Since the U.S. economy grows faster than the French economy, U.S. imports from France will grow faster than France's imports from the U.S. holding everything else constant. To buy these additional French goods the U.S. will purchase more (net) euros.(f) A demand for euros: The U.S. pays the Spanish citizen in U.S. dollars. The Spanish citizen then purchases euros so she has currency she can use in her home country.(g) A supply of euros: Since individuals holding euros expect the currency to depreciate in the near future they sell (supply) the euros today in an attempt to avoid the loss in the future.

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3. What do the plus signs and negative signs signify in the U.S. balance of payments statement? Which of the following items appear in the current account and which appear in the capital and financial account? U.S. purchases of assets abroad; U.S. services imports; foreign purchases of assets in the United States; U.S. good exports, U.S. net investment income. Why must the current account and the capital and financial account sum to zero? LO2

Answer: The plus sign (+) indicates a credit to the U.S. balance of payments. The negative sign (-) indicates a debit the U.S balance of payments.U.S. purchases of assets abroad: current accountU.S. services imports: current accountForeign purchases of assets in the United States: capital and financial accountU.S. good exports: current accountU.S. net investment income: current accountThe balance on the current account and the balance on the capital and financial account must always sum to zero because any deficit or surplus in the current account automatically creates an offsetting entry in the capital and financial account. People can only trade one of two things with each other: currently produced goods and services or preexisting assets. Therefore, if trading partners have an imbalance in their trade of currently produced goods and services, the only way to make up for that imbalance is with a net transfer of assets from one party to the other.

4. What are official reserves? How do net sales of official reserves to foreigners and net purchases of official reserves from foreigners relate to U.S. balance-of-payment deficits and surpluses? Explain why these deficits and surpluses are not actual deficits and surpluses in the overall balance of payments statement. LO2

Answer: Official reserves consist of foreign currencies, certain reserves held with the International Monetary Fund, and stocks of gold. These reserves are owned by governments or their central banks.Although the balance of payments must always sum to zero, in some years a net sale of official reserves by a nation’s treasury or central bank occurs in the process of bringing the capital and financial account into balance with the current account. In such years, a balance-of-payments deficit is said to occur. This deficit is in a subset of the overall balance statement and is not a deficit in the overall account. Remember, the overall balance of payments is always in balance. But in this case the balancing of the overall account includes sales of official reserves to create an inflow of dollars to the United States. These net sales of official reserves in the foreign exchange market show up as a plus (+) item on the U.S. balance of payments statement, specifically as foreign purchases of U.S. assets.In other years, the capital and financial account balances the current account because of government purchases of official reserves from foreigners. The treasury or central bank engineers this balance by selling dollars to obtain foreign currency, and then adding the newly acquired foreign currency to its stock of official reserves. In these years, a balance-of-payments surplus is said to exist. This payments surplus therefore can be thought of as either net purchases of official reserves in the balance of payments or, alternatively, as the resulting increase in the stock of official reserves held by the government.

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Again, the balance of payments must always sum to zero. The net sale or purchase of official reserves by a nation’s treasury or central bank occurs in the process of bringing the capital and financial account into balance with the current account. The deficit or surplus prior to the sale or purchase of reserves is a subset of the overall balance statement and is not a deficit or surplus in the overall account.

5. Generally speaking, how is the dollar price of euros determined? Cite a factor that might increase the dollar price of euros. Cite a different factor that might decrease the dollar price of euros. Explain: “A rise in the dollar price of euros necessarily means a fall in the euro price of dollars.” Illustrate and elaborate: “The dollar-euro exchange rate provides a direct link between the prices of goods and services produced in the Euro Zone and in the United States.” Explain the purchasing-power-parity theory of exchange rates, using the euro-dollar exchange rate as an illustration. LO3

Answer: The dollar price of the euro is determined in a currency exchange market that equates the supply euros with the demand for euros. A factor that might increase the dollar price of the euro could be the result of an increase in the demand for the euro or a decrease in the supply of the euro. (Examples) Increase in Demand: More Airbus aircraft purchased by U.S. airlines. Decrease in supply: Less Boeing aircraft purchased by European airlines.A factor that might decrease the dollar price of the euro could be the result of an decrease in the demand for the euro or an increase in the supply of the euro. (Examples) Decrease in Demand: Less Airbus aircraft purchased by U.S. airlines. Increase in supply: More Boeing aircraft purchased by European airlines.If the euro appreciates relative to the dollar, it takes more dollars to purchase one euro. At the same time, it takes fewer euros to buy a dollar, meaning that the euro price of dollars has fallen.Through exchange rates, residents of all trading nations can express the prices of goods and services in other trading nations in terms of their domestic currencies. A change in the exchange rate between any two countries will automatically lead to an adjustment in the prices of all goods and services in both countries in terms of the other’s currency. The determination of these price conversions represents the most basic and visible function of exchange rates. The purchasing power parity theory of exchange rates holds that exchange rates change to equal the ratios of the nations’ price levels. If a certain item costs $100 in the U.S. and 50 euros in Germany, then the exchange rate should be $1 = 0.5 euros. It should take the same amount of dollars to buy the item anywhere in the world if exchange rates adjust to maintain purchasing power parity.

6. Suppose that a Swiss watchmaker imports watch components from Sweden and exports watches to the United States. Also suppose the dollar depreciates, and the Swedish krona appreciates, relative to the Swiss franc. Speculate as to how each would hurt the Swiss watchmaker. LO3

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Answer: If the dollar depreciated relative to the franc, this means that it took more dollars to get the francs necessary to buy a watch. In other words, the watch becomes more expensive in dollar terms which would cause a decline in imported watches purchased in the United States. Second, if the krona appreciated relative to the Swiss franc, this is the same thing as saying that the franc depreciated relative to the krona. In other words, it took more Swiss francs to buy parts in Sweden than it did previously. As a result, the imported components for the watches became more expensive to the Swiss company. The Swiss watchmaker was hurt twice. Its costs rose while its export sales declined.

7. Explain why the U.S. demand for Mexican pesos is downsloping and the supply of pesos to Americans is upsloping. Assuming a system of flexible exchange rates between Mexico and the United States, indicate whether each of the following would cause the Mexican peso to appreciate or depreciate, other things equal: LO3a. The United States unilaterally reduces tariffs on Mexican products.b. Mexico encounters severe inflation.c. Deteriorating political relations reduce American tourism in Mexico.d. The U.S. economy moves into a severe recession.e. The United States engages in a high-interest-rate monetary policy.f. Mexican products become more fashionable to U.S. consumers.g. The Mexican government encourages U.S. firms to invest in Mexican oil fields.h. The rate of productivity growth in the United States diminishes sharply.

Answer: The U.S. demand for pesos is downward-sloping: When the peso depreciates in value (relative to the dollar) the United States finds that Mexican goods and services are less expensive in dollar terms and purchases more of them, demanding a greater quantity of pesos in the process. The supply of pesos to the United States is upward-sloping: As the peso appreciates in value (relative to the dollar), US. goods and services become cheaper to Mexicans in peso terms. Mexicans buy more dollars to obtain more U.S. goods, supplying a larger quantity of pesos.(a) The peso will appreciate. Mexican goods will become cheaper, so U.S. demand for pesos for will increase.(b) The peso will depreciate. The high rate of inflation in Mexico (relative the U.S.) will cause the price Mexican goods and services to increase (relative the U.S.). The U.S. demand for pesos will fall. The supply of pesos will also increase because U.S. goods are relatively cheaper. This will reinforce the depreciation of the peso.(c) The peso will depreciate. The reduction in U.S. tourism in Mexico reduces the demand for pesos.(d) The peso will depreciate. The recession in the U.S. economy will reduce imports from Mexico. This, in turn, will decrease the demand for the peso. (e) The peso will depreciate. The high interest rate in the U.S. will attract investors from Mexico. This will increase the demand for U.S. dollars or the supply of pesos.(f) The peso will appreciate. U.S. consumers purchase more goods from Mexico. This increases the demand for the peso.(g) The peso appreciates. The U.S. firms must purchase pesos to invest in Mexico. This increases the demand for pesos.(h) The peso appreciates. The sharp decline in U.S. productivity reduces investment in the U.S. by firms in Mexico. This decreases the supply of pesos.

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8. Explain why you agree or disagree with the following statements: LO3a. A country that grows faster than its major trading partners can expect the international value of its currency to depreciate.b. A nation whose interest rate is rising more rapidly than interest rates in other nations can expect the international value of its currency to appreciate.c. A country’s currency will appreciate if its inflation rate is less than that of the rest of the world.

Answer:(a) This statement is true. If high rates of economic growth mean that the real incomes

of a country’s citizens are rising more rapidly than in other countries, its imports will rise more than its exports. The demand for foreign currency by its citizens will increase more than the supply of foreign currency, causing the value of the domestic currency to decline.

(b) This statement is true. If domestic real interest rates are increasing more quickly than those in other countries, foreign financial investment will be attracted to the country, causing a rise in the supply of foreign currency and therefore an appreciation of the country’s currency.

(c) This statement is true. If a country’s inflation rate is lower than rates in other countries, the foreign prices of its products will decline relative to foreign-made products, increasing exports and the supply of foreign currency. And the domestic prices of foreign imports will increase relative to domestically made goods, decreasing the demand for foreign currency. Both factors will cause the country’s currency to appreciate.

9. “Exports pay for imports. Yet in 2009 the nations of the world exported about $379 billion more of goods and services to the United States than they imported from the United States.” Resolve the apparent inconsistency of these two statements. LO2

Answer: Exports pay for imports in the long run. In the short term, a country can import more goods and services than it exports through external borrowing or the sale of domestic assets to foreigners. Both activities increase the country’s capital account balance and cause an inflow of foreign currency that can be used to finance import purchases. Depletion of a country’s official reserves can also be used as a short-term measure to finance imports, since the sale of foreign monies for domestic currency has the same financial effect as an import transaction.

10. Diagram a market in which the equilibrium dollar price of 1 unit of fictitious currency zee (Z) is $5 (the exchange rate is $5 =Z1). Then show on your diagram a decline in the demand for zee. LO4a. Referring to your diagram, discuss the adjustment options the United States would have in maintaining the exchange rate at $5 = Z1 under a fixed-exchange-rate system.b. How would the U.S. balance-of-payments surplus that is caused by the decline in demand be resolved under a system of flexible exchange rates?

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Answer: See the graph illustrating the market for zees.

(a) The decrease in demand for zees from D1 to D2 will create a surplus (ab) of zees at the $5 price. To maintain the $5 to Z1 exchange rate, the United States must undertake policies to shift the demand-for-zee curve rightward or shift the-supply-of zee curve leftward. To increase the demand for zees, the United States could use dollars or gold to buy zees in the foreign exchange market; employ trade policies to increase imports to U.S. from Zeeonia; or enact expansionary fiscal and monetary policies to increase U.S. domestic output and income, thus increasing imports from Zeeonia and elsewhere. Expansionary monetary policy could also reduce the supply of Zees: Zeeons could respond to the lower U.S. interest rates by reducing their investing in the United States. Therefore, they would not supply as many zees to the foreign exchange market.

(b) Under a system of flexible exchange rates, the ab surplus of zees (the U.S. balance of payments surplus) will cause the zee to depreciate and the dollar to appreciate until the surplus is eliminated (at the $4 = Z1 exchange rate shown in the figure) because U.S. would import more from Zeeonia and they would buy less from U.S. since zees lost value.

11. Suppose that a country follows a managed-float policy but that its exchange rate is currently floating freely. In addition, suppose that it has a massive current account deficit. Does it also necessarily have a balance-of -payments deficit? If it decides to engage in a currency intervention to reduce the size of its current account deficit, will it buy or sell its own currency? As it does so, will its official reserves of foreign currencies get larger or smaller? Would that outcome indicate a balance-of-payments deficit or a balance-of- payments surplus? LO4

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Answer: No, if the exchange rate is floating freely this market is adjusting to bring the balance of payments into balance-no need for intervention (the current account deficit is counter-balanced by the capital account). If this country wishes to reduce its current account deficit it must make its currency ‘cheaper’ on the market. That is, it must intervene in a way that causes its currency to depreciate, which will make this county’s goods and services ‘cheaper’ on the international market. To accomplish this, the country will purchase foreign currency (increasing the supply of home currency) and accumulate more foreign reserves. Again, this country is not running a ‘balance of payments deficit’ because the exchange rate market is adjusting (interest rates are as well).

12. What have been the major causes of the large U.S. trade deficits in recent years? What are the major benefits and costs associated with trade deficits? Explain: “A trade deficit means that a nation is receiving more goods and services from abroad than it is sending abroad.” How can that considered to be “unfavorable”? LO5

Answer: (1) The U.S. economy has grown more rapidly than the economies of several major trading nations. Thus U.S. exports have not kept pace with the rise in U.S. imports. (2) Large trade deficits with China have contributed, with incomes in China too low to result in a significant increase in imports from the U.S. (3) Increases in oil prices have increased the trade deficit with OPEC nations. (4) Finally, a declining savings rate in the U.S. (while investment has remained stable) has also contributed to the trade deficit.

A trade deficit allows the Unites States to consume outside its production possibilities curve. But, the gain in current consumption comes at the expense of reduced future consumption.A trade deficit is considered “unfavorable” because it must be financed by borrowing from the rest of the world, selling off assets and dipping into foreign currency reserves. Financing of the U.S. trade deficit has resulted in a larger foreign accumulation of claims against U.S. financial and real assets than the U.S. claim against foreign assets.

13. LAST WORD Suppose Super D’Hiver—a hypothetical French snowboard retailer—wants to order 5000 snowboards made in the United States. The price per board is $200, the present exchange rate is 1 euro = $1, and payment is due in dollars when the boards are delivered in 3 months. Use a numerical example to explain why exchange-rate risk might make the French retailer hesitant to place the order. How might speculators absorb some of Super D’Hiver’s risk?

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Answer: Because payment is due in three months in dollars, the French retailer might worry that his anticipated price, which today is 1 million euros (5,000 boards at $200 when the exchange rate is 1 euro per dollar), might rise if the euro loses value relative to the dollar. For example, at the end of three months the euro could fall in value to 1.5 euros = 1 dollar, and it would take 300 to obtain $200 rather than 200 euros. For 5,000 snowboards, this increases the retailer’s cost from 1,000,000 euros to 1,500,000 euros. To protect against this risk, the retailer could purchase dollars forward—agreeing to pay a specified price for dollars in three months. The retailer would know exactly what was owed at the end of the three-month period, which would depend on the three-month forward exchange rate, which may or may not be higher than the current rate. But at least the retailer would know exactly how many euros will be needed at the end of three months to obtain the $1 million for the snowboards.Who would be willing to sign such a contract? It could be a speculator who is betting that the value of the euro will rise against the dollar rather than fall. Therefore, the speculator would be happy to sign a contract giving $1,000,000 for 1 million euros (or whatever the forward agreement is), with the expectation that these 1 million euros will be worth more than $1,000,000 in three months. Then, the speculator will have made a profit, and the retailer will have eliminated the risk of not knowing how many euros will be needed to obtain the $1 million for the snowboards. It is the speculator who has assumed the risk in this example.

PROBLEMS

1. Alpha’s balance-of-payments data for 2010 are shown below. All figures are in billions of dollars. What are the (a) balance on goods, (b) balance on goods and services, (c) balance on current account, and (d) balance on capital and financial account? Suppose Alpha sold $10 billion of official reserves abroad to balance the capital and financial account with the current account. Does Alpha have a balance-of-payments deficit or does it have a surplus? LO2

Answer: a. $10; b. $15; c. $20; d. -$20; deficit.

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Feedback: Consider the following example. Alpha’s balance-of-payments data for 2010 are shown below. All figures are in billions of dollars. What are the (a) balance on goods, (b) balance on goods and services, (c) balance on current account, and (d) balance on capital and financial account? Suppose Alpha sold $10 billion of official reserves abroad to balance the capital and financial account with the current account. Does Alpha have a balance-of-payments deficit or does it have a surplus? LO2

(a) Balance on goods: Goods Exports minus Goods Imports (reported as a negative value in table) = $40 - $30= $10 (surplus).

(b) Balance on goods and services: (Goods Exports minus Goods Imports) plus (Service Exports minus Service Imports (reported as a negative value in table)) = ($40 - $30) + ($15 - $10) = $10 + $5 = $15 (surplus).

(c) Balance on current account: (Goods Exports minus Goods Imports) plus (Service Exports minus Service Imports) plus Net Transfers (positive in table above because there was a greater inflow than outflow of transfers) plus net investment income (negative in table above because there was a greater outflow than inflow of investment income)= ($40 - $30) + ($15 - $10) + $10 +(-$5) = $20 (surplus).

(d) Balance on capital and financial account: Balance on the capital account plus (foreign purchases of assets minus purchases of assets abroad = $0 + ($20 -$40) = -$20 (deficit)

If Alpha sells $10 billion of official reserves to balance the capital and financial account with the current account, Alpha has a balance-of-payments deficit. This sale of official reserves is a flow of Alpha 'dollars' back into the country of Alpha (foreign purchase of Alpha's assets).

2. China had a $372 billion overall current account surplus in 2007. Assuming that China’s net debt forgiveness was zero in 2007 (its capital account balance was zero), by how much did Chinese purchases of financial and real assets abroad exceed foreign purchases of Chinese financial and real assets? LO2

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Answer: -$372

Feedback: Consider the following example. China had a $372 billion overall current account surplus in 2007. Assuming that China’s net debt forgiveness was zero in 2007 (its capital account balance was zero), by how much did Chinese purchases of financial and real assets abroad exceed foreign purchases of Chinese financial and real assets?To offset the current account surplus, China would have to have a deficit in the capital and financial account. Given the zero balance on the capital account, the surplus could only be achieved if China’s purchases of financial and real assets abroad exceeded foreign purchases of Chinese assets. The surplus foreign currency generated by the trade surplus would either have to go to purchase foreign assets, or be accumulated as official reserves in an amount equal to the current account surplus. Thus, the financial account would be a deficit of $372 billion.

3. Refer to following table, in which Qd is the quantity of yen demanded, P is the dollar price of yen, Qs is the quantity of yen supplied in year 1, and Qs' is the quantity of yen supplied in year 2. All quantities are in billions and the dollar-yen exchange rate is fully flexible. LO3

a. What is the equilibrium dollar price of yen in year 1?b. What is the equilibrium dollar price of yen in year 2?c. Did the yen appreciate or did it depreciate relative to the dollar between years 1 and 2?d. Did the dollar appreciate or did it depreciate relative to the yen between years 1 and 2?e. Which one of the following could have caused the change in relative values of the dollar and yen between years 1 and 2: (1) More rapid inflation in the United States than in Japan; (2) an increase in the real interest rate in the United States but not in Japan; or (3) faster growth of income in the United States than in Japan.

Answers: a. 115; b. 120; c. yen appreciated; d. dollar depreciated; (1) More rapid inflation in the United States than in Japan.

Feedback: Consider the following example. Refer to following table, in which Qd is the quantity of yen demanded, P is the dollar price of yen, Qs is the quantity of yen supplied in year 1, and Qs' is the quantity of yen supplied in year 2. All quantities are in billions and the dollar-yen exchange rate is fully flexible.

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(a) What is the equilibrium dollar price of yen in year 1?The equilibrium is 115, where Qd equals Qs (Qd = Qs =20).

(b) What is the equilibrium dollar price of yen in year 2?The equilibrium is 120, where Qd equals Q's (Qd = Q's =15).

(c) Did the yen appreciate or did it depreciate relative to the dollar between years 1 and 2?Since the price of the Yen increased (more dollars must now be given up to purchase one more Yen), the Yen as appreciated.

(d) Did the dollar appreciate or did it depreciate relative to the yen between years 1 and 2?Since the price of the Yen increased (more dollars must now be given up to purchase one more Yen), the dollar depreciated.

(e) Which one of the following could have caused the change in relative values of the dollar and yen between years 1 and 2: (1) More rapid inflation in the United States than in Japan; (2) an increase in the real interest rate in the United States but not in Japan; or (3) faster growth of income in the United States than in Japan.(1) More rapid inflation in the United States than in Japan. The increase in the relative price of goods and services in United States, as result of inflation, reduces the quantity of Yen supplied to the market as Japanese consumers buy more 'home' goods and services.

4. Suppose that the current Canadian dollar (CAD) to U.S. dollar exchange rate is $.85 CAD = $1 US and that the U.S. dollar price of an Apple iPhone is $300. What is the Canadian dollar price of an iPhone? Next, suppose that the CAD to US dollar exchange rate moves to $.96 CAD = $1 US. What is the new Canadian dollar price of an iPhone? Other things equal, would you expect Canada to import more or fewer iPhones at the new exchange rate? LO3

Answers: $255 CAD; $288; less.

Feedback: Consider the following example. Suppose that the current Canadian dollar (CAD) to U.S. dollar exchange rate is $.85 CAD = $1 US and that the U.S. dollar price of an Apple iPhone is $300. What is the Canadian dollar price of an iPhone? Next, suppose that the CAD to US dollar exchange rate moves to $.96 CAD = $1 US. What is the new Canadian dollar price of an iPhone? Other things equal, would you expect Canada to import more or fewer iPhones at the new exchange rate?

The exchange rate is $0.85 Canadian dollars for $1 U.S dollar. As a simple example, assume a candy bar costs $1 in the U.S. An individual with $0.85 Canadian cents could use this to purchase a U.S. dollar and buy the candy bar. Thus, the candy bar only costs $0.85 in Canadian dollars (=0.85 x $1).

We apply the same logic to the iPhone. The iPhone costs $300 U.S. dollars, which implies it costs $255 Canadian dollars (=0.85 x $300).

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If the CAD to US dollar exchange rate moves to $.96 CAD = $1 US, the price of the iPhone increases for Canadians (or individuals with Canadian currency) to $288 Canadian dollars (= 0.96 x $300).

Since the price of the iPhone increases for Canadians (the Canadian currency has depreciated) they will likely buy fewer (less) iPhones.

5. Return to Problem 3 and assume the exchange rate is fixed against the dollar at the equilibrium exchange rate that occurs in year 1. Also suppose that Japan and the United States are the only two countries in the world. In year 2, what quantity of yen would the Japanese government have to buy or sell to balance its capital and financial account with its current account? In what specific account would this purchase or sale show up in Japan’s balance of payments statement: Foreign purchases of assets in Japan or Japanese purchase of assets abroad? Would this transaction increase Japan’s stock of official reserves or decrease its stock? LO5

Answers: sell 10 billion yen; Japanese purchase of assets abroad; increase.

Feedback: Consider the following example. Return to Problem 3 and assume the exchange rate is fixed against the dollar at the equilibrium exchange rate that occurs in year 1. Also suppose that Japan and the United States are the only two countries in the world. In year 2, what quantity of yen would the Japanese government have to buy or sell to balance its capital and financial account with its current account? In what specific account would this purchase or sale show up in Japan’s balance of payments statement: Foreign purchases of assets in Japan or Japanese purchase of assets abroad? Would this transaction increase Japan’s stock of official reserves or decrease its stock?

The year 1 equilibrium is 115, where Qd equals Qs (Qd = Qs =20).

In year 2 the quantity of Yen supplied at the exchange rate of 115 is 10 (Qs'=10). To maintain the fixed exchange rate at 115, there would need to be an increase in the Yen supply equal to 10 (= 20 (original Qs) - 10 (new Qs')). To accomplish this the Japanese government would need to sell 10 billion Yen to balance its capital and financial account with its current account.

This would show up as Japanese purchase of assets abroad in Japan’s balance of payments statement . The sale of Yen by the Japanese government is the equivalent to (the same as) a purchase of U.S. dollars (The Japanese purchases U.S. dollars by supplying more Yen to the currency exchange market). This sale of Yen, or purchase of U.S. dollars, results in an increase in official reserves.

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The graph below demonstrates this process. The original equilibrium is 115 with a quantity of 20. The decrease in supply of Yen at every exchange rate implies the 'Supply of Yen' schedule shifts to the left. To offset this decline and maintain the fixed exchange rate of 115 the Japanese government must inject Yen into the market by purchasing U.S. dollars. This increases Japan's official reserves because they are now holding more U.S. dollars (U.S. dollars is an asset from abroad , claim against the United States).

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$/Yen

Yen

Supply of Yen

Demand for Yen

New Supply of Yen

115

20

Decrease in Supply of Yen: Market

Increase in Supply of Yen: Japanese Government

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