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The International
Monetary System
2
Chapter Two
Chapter Objective:
This chapter introduces the institutional framework
within which:
International payments are made.
The movement of capital is accommodated.
Exchange rates are determined.
Chapter 2: Outline










Basics Economics of Exchange Rate Determinations
Evolution of the International Monetaryy System
y
Current Exchange Rate Regimes
European Monetary System
Euro and the European Monetary Union
The Mexican Peso Crisis
The Asian Currencyy Crisis
The Argentine Peso Crisis
Fixed versus Flexible Exchange Rate Regimes
Recent Crisis in Ireland and Greece
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Demand For A Currency
(U.S. viewpoint)
l
Demand ((buying
y gp
pressure)) for foreign
g
exchange by U.S. corporations / traders
& speculators / governments that need to
purchase:
»
»
l
foreign-produced trade items
foreign
g assets ((real and financial).
)
Demand Curve / Schedule:
Relationship between the quantity of FX demanded & the
price of FX (exchange rate)
» Negatively sloping
»
Supply For A Currency
(U.S. viewpoint)
l
Supply (selling pressure) of foreign
exchange by foreign corporations /
traders & speculators / governments that
need to purchase:
»
»
l
U.S.-produced trade items
U.S. assets (real or financial)
Supply Curve / Schedule:
Relationship between the quantity of FX demanded & the
price of FX (exchange rate)
» Positively sloping
»
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Exchange Rate Equilibrium
(U.S. viewpoint)
Pricce of GBP in $
Equilibrium dollar price and quantity of British Pounds (GBP) are determined such that
American and British g
goods and assets are traded.
Supply Curve for GBP
$1.60
$1.55
$1 50
$1.50
Demand Curve for GBP
10
15
20
Quantity of GBP
Changes in Macro-Economic Factors &
Exchange Rates

EVENTS:






Increase/decrease in relative domestic inflation
Increase/decrease in relative domestic interest rates
Increase/decrease in relative GNP (national income)
FX trading by Governments
FX trading by speculators due to change in expectations
EFFECTS: What happens to:


The supply and demand schedules
The equilibrium exchange rate / price of the foreign currency
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The Effects of Relative Domestic
Inflation Increase in the FX Market
Demand Schedule:




Supply Schedule:




F i goods
Foreign
d are relatively
l ti l cheaper
h
t
to
domestic consumers.
Merchandise imports increase.
Quantity of FX demanded at each
exchange rate increases.
Domestic goods are relatively
expensive for foreign consumers.
Merchandise exports decrease.
Quantity of FX supplied at each
exchange rate (ER) falls.
Price of GBP in $

S2
S1
D2
D1
Equilibrium:

ER (price of GBP) increases
Quantity of GBP Exchanged
The Effects of Relative Domestic
Inflation Decrease in the FX Market
Demand Schedule:




Supply Schedule:




Foreign
g ggoods are relatively
y expensive
p
to
domestic consumers.
Merchandise imports decreases.
Quantity of FX demanded at each
exchange rate decreases.
Domestic goods are relatively cheaper for
foreign consumers.
Merchandise exports increase.
increase
Quantity of FX supplied at each ER
increases.
Priice of GBP in $

S1
S2
D1
D2
Equilibrium:

ER (price of GBP) decreases
Quantity of GBP Exchanged
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The Effects of Relative Domestic
Interest Rate Increase in the FX Market
Demand Schedule:



Supply Schedule:



D
Domestic
ti capital
it l attracted
tt t d to
t domestic
d
ti
country & domestic capital movement
overseas falls.
Quantity of FX demanded at each
exchange rate decreases.
Foreign capital attracted to domestic
country & foreign capital movement into
the domestic country increases.
increases
Quantity of FX supplied at each ER rate
increases.
Priice of GBP in $

S1
S2
D1
D2
Equilibrium:

ER (price of GBP) decreases
Quantity of GBP Exchanged
The Effects of Relative Domestic Interest
Rate Decrease in the FX Market
Demand Schedule:



Supply Schedule:



Domestic capital attracted to foreign
country & domestic capital movement
overseas increases.
Quantity of FX demanded at each
exchange rate increases.
Domestic capital attracted to domestic
country & domestic capital movement
overseas
ove
seas falls.
Quantity of FX supplied at each ER falls.
Price of GBP in $

S2
S1
D2
D1
Equilibrium:

ER (price of GBP) increases
Quantity of GBP Exchanged
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The Effects of Relative Domestic National
Income Increase in the FX Market
Demand Schedule:



Supply Schedule:



With higher
g
income,, domestic consumers
purchase more foreign goods. Merchandise
imports increase.
Quantity of FX demanded at each exchange
rate increases.
Either foreign demand for domestic goods
does not change or increases with increased
foreign dollar purchasing power
Quantity of FX supplied at each ER does
not change or increases.
Price of GBP in $
P

S1
S2
D2
D1
Equilibrium:

ER (price of GBP) increases
Quantity of GBP Exchanged
The Effects of Relative Domestic National
Income Decrease in the FX Market
Demand Schedule:



Supply Schedule:



With lower income,, domestic consumers
purchase less foreign goods. Merchandise
imports decrease.
Quantity of FX demanded at each exchange
rate decreases.
Either foreign demand for domestic goods
does not change or decreases with
decreased foreign dollar purchasing power
Quantity of FX supplied at each ER does
not change or decreases.
S2
Prrice of GBP in $

S1
D1
D2
Equilibrium:

ER (price of GBP) decreases
Quantity of GBP Exchanged
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Expectations About Currency Prices and
Trading Strategy in FX Market: Theory

Based on expectations about future behavior of macro
economic
i variables,
i bl currency traders:
d



Make predictions about expected changes in foreign currency prices
Based on these expectations:
 Borrow in currency that is expected to depreciate
 Lend in currency that is expected to appreciate
This changes the supply/demand and the price for foreign currency in
the FX market
Expectations About Currency Prices and
Trading Strategy in FX Market: Example
Eurobank can borrow/lend Dollars (USD) at 4%. It can also borrow/lend
British Pounds (GBP) and Mexican Pesos (MXN) at 6%. It has access to
15,000,000 dollars (or equivalent amounts of GBP and MXN) for currency
speculation
How can Eurobank make trading profits:
1. If it expects GBP to appreciate from $1.50 to $1.65 in 90 days.
2. If it expects MXN to depreciate from $0.20 to $0.18 in 60 days.
R
Remember:
b
Borrow in the depreciating currency
Lend in the appreciating currency
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Eurobank’s Trading Strategy if BP is Expected to
Appreciate: How it Effects the FX Market
S1
Pricce of GBP in $
Today:
- Borrow $15 million for 90 days (@ 4% / yr)
from US Bank
- Buy pounds, $15 million / 1.50 = GBP10 mil
- Lend BP10 million for 90 days (@ 6% / yr) to
UK Bank
90 Days Later:
- Withdraw GBP10,150,000 from UK Bank
(10,000,000 [1 + .06 (90/360)]
- Convert pounds to dollars @$1.65:
(10,150,000*1.65) = $16,747,500
- Pay off loan to US Bank: (15,000,000
[1+.04*(90/360)] = $15,150,000
- Total profit = $16,747,500 - $15,150,000 =
$1,597,500
- Annualized percentage profit = (1,597,500 /
15,000,000) *(360/90)*100 = 42.60%.
D2
D1
Quantity of GBP Exchanged
Eurobank’s Trading Strategy if MP is Expected to
Depreciate : How it Effects the FX Market
S1
Pricce of MXN in $
Today:
- Borrow FF75 million for 60 days (@ 6% / yr)
f
from
a Mexican
M i
(MX) Bank
B k
- Sell FF (for $): MP75 mil / 0.20 = $15 mil
- Lend $15 million for 60 days (@ 4% / yr) to US
Bank
90 Days Later:
- Withdraw (15,000,000 [1 + .04 (60/360)]
$15,100,000 from US bank
- Convert dollars to MXN @ $0.18: (15,100,000
/0.18) = MXN 83,888,889
- Pay
P off
ff lloan tto MX B
Bank:
k (75
(75,000,000
000 000
[1+.06*(60/360)] = MXN 75,750,000
- Total profit = 83,888,889 - 75,750,000 = MXN
8,138,889
- Annualized percentage profit = (8,138,889 /
75,000,000) *(360/60)*100 = 65.11%.
S2
D1
Quantity of MXN Exchanged
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How Governments Impact FX
Market?
Governments may increase or decrease trade
restrictions (tariffs & quotas)
Governments may directly intervene in the FX
markets. If a foreign currency price is perceived to be
abnormally low or high with respect to the US dollar,
both the US Central bank and the central bank of
other countries may agree to buy or sell the foreign
currency (against the dollar) to reverse this trend.
The US Government Increases Trade
Restrictions
Trade Restriction Increase in US:



IImportt duties
d ti on UK goods
d (tarrifs)
(t if ) are
increased
Quotas on goods imported from UK into
US are reduced
Demand Schedule:


Fewer UK goods will be imported
Quantity of FX demanded at each ER
decreases

Supply Schedule

Equilibrium:


S1
Pricce of GBP in $

D1
D2
Will not change
ER (price of GBP) decreases
Quantity of GBP Exchanged
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The US Government Decreases Trade
Restrictions
Trade Restriction Decrease in US:



IImportt duties
d ti on UK goods
d (tarrifs)
(t if ) are
decreased
Quotas on goods imported from UK into
US are increased
Demand Schedule:


More UK goods will be imported
Quantity of FX demanded at each ER
increases

Supply Schedule

Equilibrium:


S1
Pricce of GBP in $

D2
D1
Will not change
ER (price of GBP) increases
Quantity of GBP Exchanged
The Foreign Government Increases
Trade Restrictions
Trade Restriction Decrease in US:


IImportt duties
d ti on US goods
d (tarrifs)
(t if ) are
increased in the UK
Quotas on goods imported from US into
UK are decreased

Demand Schedule:

Supply Schedule




Will not change
Fewer US g
goods will be sold in UK
Quantity of FX supplied at each ER
decreases
S2
Pricce of GBP in $

S1
D1
Equilibrium:

ER (price of GBP) increases
Quantity of GBP Exchanged
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The Foreign Government Decreases
Trade Restrictions
Trade Restriction Decrease in US:


IImportt duties
d ti on US goods
d (tarrifs)
(t if ) are
decreased in the UK
Quotas on goods imported from US into
UK are increased

Demand Schedule:

Supply Schedule



Will not change
More US g
goods will be sold in UK
Quantity of FX supplied at each ER
increases
S1
Pricce of GBP in $

S2
D1
Equilibrium:


ER (price of GBP) decreases
Quantity of GBP Exchanged
Government Intervention in the FX
Market: Non-Sterilized (1)

If GBP is undervalued (dollar is overvalued):

Both Central banks buy GBP (sell USD dollars):



US money supply rises and the British money supply falls
US inflation increases and British inflation decreases
Appreciation of GBP (depreciation of dollar) is more due
to increased US inflation (decreased British inflation)
rather than central bank transactions in the FX market
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Government Intervention in the FX
Market: Non-Sterilized (2)

If GBP is overvalued (dollar is undervalued ):

Both central banks sell GBP (buy USD):



US money supply falls and the British money supply rises
US inflation decreases and British inflation increases
Depreciation of GBP (appreciation of dollar ) is more due
to decreased US inflation (increased British inflation)
rather than central bank transactions in the FX market
Government Intervention in the FX
Market: Sterilized (1)

If GBP is undervalued (dollar is overvalued ):

Both Central banks buy GBP (sell USD):


To neutralized the changes in money supply: Federal
Reserve sells US Treasury securities and the Central Bank
of England buys British Treasury securities


US money supply rises and the British money supply falls
US money supply is reduced and the British money supply is increased
The GBP appreciation (dollar depreciation ) due to central
bank intervention is usually short lived
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Government Intervention in the FX
Market: Sterilized (2)

If GBP is overvalued (dollar is undervalued ):

Both central banks sell GBP (buy USD):


To neutralized the changes in money supply: Federal
Reserve buys US Treasury securities and the Central Bank
of England sells British Treasury securities


US money supply falls and the British money supply rises
US money supply is increased and the British money supply is reduced
The GBP depreciation (dollar appreciation ) due to central
bank transaction is usually short lived
Changes in the Value of a Country’s
Monetary Unit and the Exchange Rate

A monetary unit is valued as a:

store of value: this is determined by:



medium of exchange (liquidity): this is determined by :



Stability of the nation’s monetary policy
Reputation and independence of its Central bank
GNP Growth
Demand for the nation’s assets
Higher monetary value leads to higher demand
and higher value for its currency
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Evolution of the
International Monetary System




Bimetallism and Classical Gold Standard: Pre-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973-Present
Bimetallism: Before 1875



A “double standard” in the sense that both gold
andd silver
il
were usedd as money.
Some countries were on the gold standard, some
on the silver standard, some on both.
Both gold and silver were used as international
means of payment and the exchange rates among
currencies were determined by either their gold or
silver contents.
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Gresham’s Law


Gresham’s Law implied that it would be the
l
least
valuable
l bl metall that
h would
ld tendd to circulate.
i l
Suppose that you were a citizen of Germany
during the period when there was a 20 German
mark coin made of gold and a 5 German mark
coin made of silver.

If Gold suddenly and unexpectedly became much
more valuable than silver, which coins would you
spend if you wanted to buy a 20-mark item and
which would you keep?
Classical Gold Standard:
1875-1914

During this period in most major countries:




Gold alone was assured of unrestricted coinage
There was two-way convertibility between gold and
national currencies at a stable ratio.
Gold could be freely exported or imported.
The exchange rate between two country
country’ss
currencies would be determined by their relative
gold contents.
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Classical Gold Standard:
1875-1914
For example, if the dollar is pegged to gold at
U S $30 = 1 ounce of gold
U.S.
gold, and the British
pound is pegged to gold at £6 = 1 ounce of
gold, it must be the case that the exchange rate
is determined by the relative gold contents:
$30 = 1 ounce of gold = £6
$30 = £6
The exchange rate: £1 = $5
2-30
What happens if 1£ trades for $6?
Classical Gold Standard:
1875-1914


Highly stable exchange rates under the classical
gold standard provided an environment that was
conducive to international trade and investment.
Misalignment of exchange rates and international
imbalances of payment were automatically
corrected by the price
price-specie-flow
specie flow mechanism
mechanism.
2-31
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Price-Specie-Flow Mechanism


Suppose Great Britain exported more to France than
F
France
iimportedd from
f
G
Great
B
Britain.
i i
This cannot persist under a gold standard.



Net export of goods from Great Britain to France will be
accompanied by a net flow of gold from France to Great
Britain.
This flow of gold will lead to a lower price level in France
and, at the same time, a higher price level in Britain.
The resultant change in relative price levels will slow
exports from Great Britain and encourage exports from
France.
Classical Gold Standard: 1875-1914

There are shortcomings:


The supply of newly minted gold is so restricted that
the growth of world trade and investment can be
hampered for the lack of sufficient monetary reserves.
Even if the world returned to a gold standard, any
national government could abandon the standard.
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Interwar Period: 1915-1944



Exchange rates fluctuated as countries widely
used “predatory” depreciations of their currencies
as a means of gaining advantage in the world
export market.
Attempts were made to restore the gold standard,
but participants lacked the political will to
“follow the rules of the game”.
The result for international trade and investment
was profoundly detrimental.
Bretton Woods System: 1945-1972




Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
The purpose was to design a postwar
international monetary system.
The goal was exchange rate stability without the
gold standard
standard.
The result was the creation of the IMF and the
World Bank.
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Bretton Woods System: 1945-1972



Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.
Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par
value by buying or selling foreign reserves as
necessary.
The Bretton Woods system was a dollar-based
gold exchange standard.
Bretton Woods System: 1945-1972
British
pound
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
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The Flexible Exchange Rate Regime:
1973-Present.

Flexible exchange rates were declared acceptable
to the IMF members.



Central banks were allowed to intervene in the
exchange rate markets to iron out unwarranted
volatilities.
Gold was abandoned as an international reserve
asset.
Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.
Value of USD: A Historical Perspective
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Classification of Exchange Rate
Regimes
Exchange Rate Reserve Assets
T
Type
Convertibility
1. Fixed
A. Gold
I. Full
2. Crawling Peg
B. US Dollar and Hard II. Dual Market
Currencies
3. Managed Float
C. SDRs
III. Controlled
4. Free Float
Exchange Rate

Free Float



Managed Float
Pegged to another currency



The largest number of countries, about 48, allow market forces
to determine their currency’s value.
Such as the U.S. dollar or euro (through franc or mark).
About 25 countries combine government intervention with
market forces to set exchange rates.
No national currency

Some countries do not bother printing their own currency. For
example, Ecuador, Panama, and El Salvador have dollarized.
Montenegro and San Marino use the euro.
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European Monetary System


European countries maintain exchange rates
among their currencies within narrow bands, and
jointly float against outside currencies.
Objectives:



To establish a zone of monetary stability in Europe.
To coordinate exchange rate policies vis-à-vis nonEuropean currencies.
To pave the way for the European Monetary Union.
What Is the Euro?


The euro is the single currency of the European
Monetary Union which was adopted by 11
Member States on 1 January 1999.
These original member states were: Belgium,
Germany, Spain, France, Ireland, Italy,
Luxemburg Finland,
Luxemburg,
Finland Austria,
Austria Portugal and the
Netherlands.
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The Maastricht Criteria
The Maastricht Treaty stipulated five criteria that European
countries had to meet to become eligible for Euro:
 Price Stability: A country's inflation rate must not exceed the average inflation
rate of the 3 best performing member states by more than 1.5%.
 The Level of Government Deficit : The government’s budget deficit must not
be more than 3 % of its gross domestic product.
 The Level of Government Debt : The government’s total debt must not be
more than 60 % of its gross domestic product.
 Successful EMS Membership : A country must have participated in Exchange
Rate Mechanism of the European Monetary System for at least two years,
without devaluing against the currency of any other Member State.
 Interest-Rate Convergence : Its average nominal long-term interest rate
should not be more than 2 % higher than those prevailing in the three best
performing Member States in terms of price stability.
How Did the Euro Affect Contracts
Denominated in National Currency?


All insurance and other legal contracts
continued in force with the substitution of
amounts denominated in national currencies
with their equivalents in euro.
Once the changeover was completed by July 1,
2002 the legal
2002,
legal-tender
tender status of national
currencies (e.g. German mark, Italian lira) was
cancelled, leaving the euro as the sole legal
tender in the euro zone.
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Euro Area







Austria,
A
i
Belgium,
Cyprus,
Finland,
France,
Germany
Germany,
Greece,








IIreland,
l d
Italy,
Luxembourg,
Malta,
The Netherlands,
Portugal
Portugal,
Slovenia,
Spain
Value of the Euro in U.S. Dollars
24
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The Long-Term Impact of the Euro



As the euro proves successful, it will advance the
political integration of Europe in a major way,
eventually making a “United States of Europe”
feasible.
It is likely that the U.S. dollar will lose its place as
the dominant world currency.
currency
The euro and the U.S. dollar will be the two major
currencies.
Costs of Monetary Union

The main cost of monetary union is the loss of
national monetary and exchange rate policy
independence.

The more trade-dependent and less diversified a
country’s economy is the more prone to asymmetric
shocks that country’s economy would be.
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Costs of Monetary Union


As an example, if the economy of Oklahoma was
dependent on gas and oil, and oil prices fall on the
world market, then Oklahoma might be better off
if it had its own currency rather than relying on
the U.S. dollar.
This example shows that perhaps the benefits of
monetary union typically outweigh the costs.
A Single European Currency: Possible
Advantages









Next Logical Step: A single market concept cannot survive for long without a
single currency
Transaction Costs: Reduce the cost of converting
g currencies
No Exchange Rate Uncertainty: Eliminates the risks of unforeseen
exchange rate revaluations or devaluations.
Transparency & Competition : Increase direct comparability of prices and
wages across Europe
Strength: The new Euro will be the among the strongest currencies in the
world, along with the US Dollar and the Japanese Yen.
Capital
p
Market: A larger
g Euro zone will integrate
g
the European
p
financial
markets
No Competitive Devaluations: Countries can no longer devalue their
currencies against each other to increase their exporters
Fiscal Discipline: Governments with a lack of fiscal discipline can be
brought into line.
European Identity: One currency will strengthen the European identity.
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A Single European Currency: Possible
Disadvantage






Cost of Introduction: Converting all bills, all wages and prices into Euro
is expensive
Non-Synchronicity of Business Cycles: Business cycles across the
various countries do not move in synchronicity.
Fiscal Policy Spillovers: With a Europe-wide interest rate, individual
countries that increase their debt will raise interest rates in all other
countries
No Competitive Devaluations: In a recession, a country can no longer
stimulate its economy by devaluing its currency and increasing exports.
C
Central
Bank Independence: It will be difficult
ff
for
f the new European
Central Bank (ECB) to maintain its independence, in spite of pressure
from member countries
Excessive Fiscal Discipline: The pressure on a member government to
limit budget deficit could adversely affect that country’s economy
The Mexican Peso Crisis




On 20 December, 1994, the Mexican government
announced a plan to devalue the peso against the
dollar by 14 percent.
This decision changed currency trader’s
expectations about the future value of the peso.
They stampeded for the exits.
exits
In their rush to get out the peso fell by as much as
40 percent.
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10/12/2011
The Mexican Peso Crisis
The Mexican Peso Crisis

The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.
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10/12/2011
The Mexican Peso Crisis

Two lessons emerge:


It is essential to have a multinational safety net in
place to safeguard the world financial system from
such crises.
An influx of foreign capital can lead to an
overvaluation in the first place.
The Asian Currency Crisis



The Asian currency crisis turned out to be far
more serious than the Mexican peso crisis in
terms of the extent of the contagion and the
severity of the resultant economic and social
costs.
Many firms with foreign currency bonds were
forced into bankruptcy.
The region experienced a deep, widespread
recession.
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10/12/2011
Fall of the Thai Baht and other SE
Asian Currencies
The Argentinean Peso Crisis


In 1991 the Argentine government passed a
convertibility law that linked the peso to the U.S.
dollar at parity.
The initial economic effects were positive:



Argentina’s chronic inflation was curtailed
Foreign investment poured in
As the U.S. dollar appreciated on the world
market the Argentine peso became stronger as
well.
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10/12/2011
The Argentinean Peso Crisis

The strong peso hurt exports from Argentina and
caused a protracted economic downturn that led to
the abandonment of peso–dollar parity in January
2002.


The unemployment rate rose above 20 percent
The inflation rate reached a monthlyy rate of 20 ppercent
The Argentinean Peso Crisis
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10/12/2011
The Argentinean Peso Crisis

There are at least three factors that are related to
the collapse of the currency board arrangement
and the ensuing economic crisis:



Lack of fiscal discipline
Labor market inflexibility
Contagion
Co
g o from
o thee financial
c crises
c ses in Brazil andd Russia
uss
Currency Crisis Explanations




In theory, a currency’s value mirrors the fundamental
strength of its underlying economy
economy, relative to other
economies. In the long run.
In the short run, currency trader’s expectations play a
much more important role.
In today’s environment, traders and lenders, using the
most modern communications, act by fight-or-flight
i ti t For
instincts.
F example,
l if they
th expectt others
th are about
b t to
t
sell Brazilian reals for U.S. dollars, they want to “get to
the exits first”.
Thus, fears of depreciation become self-fulfilling
prophecies.
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10/12/2011
Fixed versus Flexible
Exchange Rate Regimes

Arguments in favor of flexible exchange rates:



Easier external adjustments.
National policy autonomy.
Arguments against flexible exchange rates:


Exchange rate uncertainty may hamper international
trade.
No safeguards to prevent crises.
Fixed versus Flexible
Exchange Rate Regimes



Suppose the exchange rate is $1.40/€ today.
In the next slide, we see that demand for euro far
exceeds supply at this exchange rate.
The U.S. experiences trade deficits.
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10/12/2011
Dollar price pper €
(exchange ratte)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Demand
(D)
$1 40
$1.40
Trade deficit
QS
QD
Q of €
Flexible
Exchange Rate Regimes

Under a flexible exchange rate regime, the dollar
will simply depreciate to $1.60/€, the price at
which supply equals demand and the trade deficit
disappears.
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10/12/2011
Dollar price pper €
(exchange ratte)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
$1.60
$1 40
$1.40
Demand
(D)
Dollar depreciates
(flexible regime)
Demand (D*)
QD = QS
Q of €
Fixed versus Flexible
Exchange Rate Regimes


Instead, suppose the exchange rate is “fixed” at
$1.40/€, and thus the imbalance between supply
and demand cannot be eliminated by a price
change.
The government would have to shift the demand
curve from D to D
D*

In this example this corresponds to contractionary
monetary and fiscal policies.
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10/12/2011
Dollar price pper €
(exchange ratte)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Contractionary
policies
li i
(fixed regime)
Demand
(D)
$1 40
$1.40
Demand (D*)
QD* = QS
Q of €
36