2013 Cambridge Business & Economics Conference
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Teaching Fixed Exchange Rates and Stockpiled Reserves to Undergraduates:
Updating Demand and Supply
Jannett Highfill
Bradley University
Department of Economics
(309) 677-2304
Raymond Wojcikewych
Bradley University
Department of Economics
(309) 677-3286
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Teaching Fixed Exchange Rates and Stockpiled Reserves to Undergraduates:
Updating Demand and Supply
ABSTRACT: The paper argues that fixed exchange rates need to be taught to undergraduates
because they are closely related to the kind of export-led growth strategies that have been
successful for such countries as Japan, South Korea, and China. The paper further argues that
supply and demand provides a useful framework for teaching fixed exchanged rates—providing
non-linear demand functions are used. We argue in favor of isoelastic demand. The problem for
instructors is that drawing graphs for power point slides or coming up with numerical examples
for homeworks and exams becomes somewhat time-consuming. The major work of the paper is
to provide a simple way of finding parameter sets that generate good teaching examples.
INTRODUCTION
While the global financial crisis dominated the economic news in recent years, the
growing stockpiles of international reserves held by some countries have prompted a lingering
debate as to the motives behind these massive accumulations. Leading the list of countries with
some of the largest foreign reserves are three Asian economic superpowers, namely, China,
Japan, and Korea. Just prior to the global crisis these three countries alone held 44%, or nearly
half, of world reserves, around $1.6 trillion (IMF Annual Report, 2005). Today, China and
Japan still top the world list with over $3.7 trillion in foreign reserves, while Korea’s holdings
($315 billion) keep it in the top ten world rankings (Global Finance, 2012).
Economists continue to debate the underlying reasons for these huge accumulations of
foreign reserves. In the present paper we argue that in a purely market- determined exchangeJuly 2-3, 2013
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rate system, the exchange rate will adjust to balance out trade and capital flows. In other words,
it seems impossible for a country to be able to accumulate foreign reserves without manipulating
its exchange rate. Paul Krugman in his New York Times column recently came to a similar
conclusion:
Some observers question whether we really know that China’s currency is
undervalued. But they’re kidding right? The flip side of the manipulation that
keeps China’s currency undervalued is the accumulation of dollar reserves
(Krugman, 2011).
In this view, a country maintains an under-valued currency in order to promote its exports
and thereby fuel economic growth. Resisting a revaluation of its currency requires selling
domestic currency and buying foreign currencies. The latter is the source of foreign reserves
accumulation. China, Japan, and Korea, at various times over the past four decades, have been
accused of this type of modern mercantilist policy.
An alternative explanation for the hoarding of reserves is the “self-insurance or
precautionary demand” motive. In this view, foreign reserves act as a stabilizer defending
against a possible drop in a country’s output or capital flight. Aizenman and Lee (2008) argue
that the slowing of economic growth may in fact have provided motivation for both
precautionary hoarding and modern mercantilism in the case of Japan and Korea. They argue the
two motives can in fact reinforce each other. Hoarding reserves as a precaution against financial
crises also promotes a competitive (undervalued?) exchange rate.
China’s phenomenal economic performance (since 1991 at least) is often compared to
Japan’s rise during the 1950’s and 1960’s. According to Ito (2006) similarities between the two
countries during the respective time periods include rapid economic growth fueled by
manufacturing, capital controls, increasing foreign reserves, and a dollar peg. (See also Obstfeld
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(2007) for an analysis of these similarities.) Differences between the two countries, however,
include a bigger reliance on the part of China on FDI for its growth, and, more moderate
inflation in China whereas Japanese inflation was high (particularly in the mid 70’s when Japan
transitioned off the dollar peg).
South Korea’s economic ascendency followed Japan’s (but was before China’s) in its
export-led growth strategy. The U.S. declared Korea an “exchange rate manipulator” under the
Omnibus Trade Act of 1988 (Obstfeld, 2007). Over the period of 1973-1995, Korea was the
country with the highest GDP per capita (Ito, 2006, 43). A common thread in the case of all
three countries during their respective economic growth periods was a “fear of float” (Calvo and
Reinhart, 2002). This fear of fluctuating exchange rates, in turn, fed the need for some sort of
currency manipulation and concomitant foreign reserve accumulation.
As noted earlier, massive international reserves accumulations can also be motivated by
fear of crises of one kind or another. Some observers note that a financial bubble in China in
recent years is similar to bubbles in Japan and South Korea in the past that precipitated crises in
those countries. Credit as a percentage of GDP in China jumped from 122% in 2008 to 171% in
2010. If this credit bubble should burst (as it did in Japan in the early 90’s and South Korea a
few years later), the resulting banking crisis could have serious negative consequences for
China’s growth and stability. While Japan and Korea were unable to offset their respective
crises, China, many believe, is better situated to stabilize any capital outflows and/or output
declines given its vast international reserves.
As a growth strategy, reliance by emerging economies on exports to drive their GDP
engine appears to have a “life cycle.” While China is held up as the model of export-led
efficiency, it should be noted that net exports contributed nothing to China’s growth in 2011(The
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Economist, May 2012, 11). Pressure from major trading partners also limits currencymanipulation as part of a country’s economic policy. Last fall the U.S. Senate passed a bill that
calls for retaliation against any country that generates a large surplus with an undervalued
currency (The Economist, May 2012, 5).
A generation ago many economists thought that exchange rates would by now be all
market determined, and many textbooks even now seem to be written that way. To be absolutely
clear, this paper is not about China, Japan, or South Korea per se. We believe, however, that
these countries experiences demonstrate that a world of all flexible exchange rates has not yet
arrived. Nor, we would argue, will such a world be soon in coming. It seems likely that other
major countries will take note of the development path of these examples and use a similar
strategy. An immediate implication is that it is important to be able to talk in easy intuitive
ways about what happens when the market for foreign exchange is not in equilibrium—the
implications of the systematic under-valuing of one currency and the over-valuing of the other—
and the implications for the financial markets in the country whose currency is over-valued.
Essentially a demand and supply for foreign exchange analysis—warts and all—should
be in the bag of teaching tools because it connects exchange rates with currency trading volumes.
As will be seen later, we ourselves use demand and supply for foreign exchange in some slightly
unconventional ways. But whether you use our tools or the convention “X” demand and supply
picture—it is essential to have tools to connect, for example, an over-valued dollar in the dollaryuan market with China’s need to find ways to hold its dollars reserves. Implementing these
ideas runs into an immediate technical snag. Students often master abstract concepts best when a
numerical example or two is presented. For a demand and supply model linear curves are often
the first choice of instructors because it is easy to find the slopes and intercepts to generate the
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desired equilibrium (or disequilibrim). The problem is that linear demand and supply curves do
not make much pedagogical sense in the case of the market for foreign exchange. As everyone
who has ever taught exchange rates has explained, the demand for say, dollars in the dollar-yuan
market is the same thing as the supply of yuan. To demand dollars is to supply yuan. But a
linear demand function does not generate a linear supply function (or anything even close). (The
Appendix gives a simple example of this.) The next easiest functional form, unit-elastic demand
curves give rise to perfectly inelastic supply curves—also not pedagogically ideal.
Thus the present paper proposes that exchange rates be taught with isoelastic demand
curves. Doing so, when the demand is elastic, eliminates the pedagogical problems of a
backward bending or vertical supply curve. But by introducing isoelastic demand finding
numerical examples becomes a little tougher because there are both exponents and shift
parameters. The main goal of the present paper is to suggest a simple algebraic strategy for
producing numerical examples for the classroom.
This is perhaps a modest goal. Examples can always be found by trial and error. But a
unit that takes too long to prepare might well end up on the cutting room floor so to speak, even
when the instructor is convinced of the topic’s importance. In the competition for scarce space
on a syllabus, simplifying a unit’s preparation improves the odds that it is covered. And we
believe the exchange rate/financial market implications of export-led growth are simply too
important to the world economy to ever be omitted in a one semester principles class, or
anywhere else. We hope to facilitate classroom coverage of the market basics of exchange rates
by making it quite easy to produce numerical examples.
MARKET BASICS
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Consider first agents holding dollars who want to exchange them for yuan. Assume a
constant elasticity of demand for yuan function where QD¥ is quantity demanded,
$
is the value of
¥
the yuan, n¥ is the price elasticity and a ¥ is a constant :
$
QD¥  a¥  
¥
$
¥
 Q¥ 
 D 
 a¥ 
 n¥
(1)
1/ n¥
(2)
1/1 n¥
¥  a¥ 


$  QS$ 
1
 
QD¥   a¥ 1n¥ QS$
(3)
n¥
n¥ 1
.
(4)
These four equations contain the same economic information. The second is simply the inverse
demand function to making graphing easy for students. The third is the (indirect) supply of
dollars function using the exchange rate identity $ / ¥  QS$ / QD¥ . The fourth is what we call the
“Want Yuan” offer curve—giving the relationship between yuan demanded and dollars supplied.
(See Figure 2 and its discussion below.)
Although no doubt some in-class time would be spent talking about the motives for
participating in this market and example transactions given, this material is perhaps familiar
enough to be omitted here.
A typical part of that discussion is the fact that the demand for
yuan implies a supply of dollars and conversely.
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Table 1: Want yuan, have dollars
Yuan Quantity Quantity Dollar
per
of
of
per
Dollar Dollars
Yuan
Yuan
10
48.28
A 4.82
0.207
15
90
B
6
0.167
20
140
C
7
0.143
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In Table 1, the demand for yuan curve is derived by simply mapping the first two columns, and
the supply of dollars by mapping the last two. (See Figure 1 and its discussion below.)
The analysis for agents holding yuan who want to exchange them for dollars is similar.
Again assuming a constant elasticity of demand for dollars function where QD$ is quantity
demanded,
¥
is the value of the dollar, n$ is the price elasticity and a$ is a constant :
$
¥
QD$  a$  
$
¥  QD$ 


$  a$ 
$
¥
 n$
(5)
1/ n$
(6)
1/1 n$
a 
  $¥ 
 QS 
1
 
QS¥   a$  n$ QD$
(7)
n$ 1
n$
.
(8)
These are the four analogous equations to those above. A numerical example is given in Table 2.
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Table 2: Want dollars, have yuan
Yuan Quantity Quantity Dollars
per
of
of
per
Dollar Dollars
Yuan
Yuan
12
84
a
7
0.143
15
90
b
6
0.167
20
98.37
c 4.92
0.203
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The demand for dollars is the first two columns and the supply of yuan is the last two.
Figure 1 shows the traditional demand and supply approach. The demand for yuan and
the equivalent supply of dollars is shown by the dashed lines. The points A, B, and C from Table
1 are plotted as shown. The demand for dollars and equivalent supply of yuan are the solids
lines; the points a, b, and c from Table 2 are plotted as well.
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Market for Yuan
Market for Dollars
Value of Yuan
Value of Dollar
14
0.8
12
0.6
Supply of Yuan
10
Supply of Dollars
8
a
0.4
B
6
b
A
0.2
B
a b
50
4
c
A
Demand For Dollars
Demand for Yuan
2
C
100
C
c
150
200
Yuan
5
10
15
20
25
Dollars
Figure 1: Demand and supply approach
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As alert students will have noticed by now, the equilibrium value of the dollar is 6 (and the value
of the yuan 1/ 6  1.67 ). But we believe the focus on quantities in the market for foreign
exchange is especially appropriate when the exchange rate is not in equilibrium. Thus, when the
value of the dollar is set at 7 (and the value of the yuan 1/ 7  1.43 ) the dollar is over-valued and
the yuan is under-valued. Although the implications for currency reserves can be seen in Figure
1 we believe they are somewhat easier for students to see in Figure 2.
Looking again at Table 1, the information in the demand for yuan (or equivalently the
supply of dollars) is also contained in the two middle columns of the table. Using an analogy
from trade theory, we graph the middle two columns in the dollar-yuan space and call the
resulting curve the “Want Yuan” offer curve. (This method is explained in more detail in
Highfill and Wojcikewych (2011); comparative statics which are not in the present paper are in
Highfill and Wojcikewych (2012).) The points A, B, and C are plotted just as they were in
Figure 1. Notice with the quantities on the axes, the exchange rate (the value of the dollar, the
variable on the horizontal axis) is the slope of any ray from the origin. The intuitive explanation
for students of this offer curve is that as the value of the dollar rises (and the yuan falls) Chinese
goods become cheaper for Americans and they demand more of them. Demanding more
Chinese goods means they need more yuan, and supply more dollars to obtain them. But notice
that the Want Yuan offer curve is convex up. The intuitive explanation is that as the dollar gains
value it takes smaller and smaller increments in number of dollars supplied to get equal
increments in yuan demanded. (The curve is getting steeper.)
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Yuan
200
Want Yuan
C
150
100
a
50
c
b
B
Want Dollars
15
20
A
5
10
25
Dollars
Figure 2: Offer curve approach
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The “Want Dollars” offer curve is derived from the middle two columns of Table 2. The
intuitive explanation for its slope is similar—with the appropriate adjustments for the fact that
the currency demanded is on the horizontal axis rather than the vertical one. As the value of the
dollar falls Chinese demand more U.S. good, more dollars, and supply more yuan to get them.
But here the slope is getting flatter—as the yuan gains more and more value, a smaller yuan
increment is needed to obtain any given dollar increment.
The equilibrium value of the dollar is the slope of the ray going through the B-b point,
i.e., 6—although the ray is not shown to keep the picture as simple as possible. But when the
dollar is (over)valued at 7 yuan, Americans will find (as compared to equilibrium) that their
dollars go further and they will buy more Chinese goods (or assets etc.). They want 140 yuan
and supply 20 dollars to get them. On the other hand, Chinese agents will find American goods
and assets more expensive (compared to equilibrium) and desire 12 dollars and supply 84 yuan
to get them. So, looking at the yuan axis, Americans desire 140 yuan but private agents in China
will supply only 84 yuan. The Chinese government must supply the difference, 56 yuan, the
vertical distance between the dashed lines in Figure 2. Overvaluing the dollar is seen to be a
feasible strategy for the Chinese government because they can always print the necessary yuan.
Looking now at the dollar axis, Americans have supplied 20 dollars but private Chinese agents
only want 12 dollars. This difference, 8 dollars, is the number of dollars the Chinese government
has to absorb. This is the horizontal distance between the dashed lines in Figure 2.
Whichever method is preferred, both Figures 1 and 2 help students “see” the key point—
that an export-led growth strategy of overvaluing the dollar is precisely a policy of accumulating
dollars reserves. No country can have a sustained export-led growth strategy of selling to the
U.S. market without accumulating vast sums of dollars.
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FINDING PARAMETERS
The primary argument of the present paper is that to use a teaching strategy something
like the one suggested here, it is quite helpful to use numerical examples. But the trial and error
method of finding them is time consuming. The present section shows how to begin with
whatever solution you want to show the students in terms of the equilibrium exchange rate,
disequilibrium exchange rate, and currency quantities, and then find the parameter set that
generates them.
For numerical examples there is usually a tradeoff between realistic numbers and
something simple enough students can follow in class. The example above attempts a middle
path, exchange rates that are ballpark correct, but simple enough quantities that at least some
lines of the tables are intuitive. Different people with different teaching philosophies may
emphasize one goal over the other. The method which follows allows for easy construction of
numerical examples to match the specific teaching goals.
As perhaps is apparent, we want to find parameters which produce relatively transparent
numbers for five variables: (1) the flexible/equilibrium value of the dollar, (2) the quantity of
dollars with a flexible/equilibrium exchange rate, (3) a fixed value of the dollar, (4) the quantity
of dollars demanded at that fixed exchange rate, and (5) the quantity of dollars supplied at that
fixed exchange rate. (The fixed and flexible value and quantities of the yuan are, of course,
implied by these.)
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Table 3 summarizes our choices for these in the example above.
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Table 3: Teaching example starting values
Q$flex  15
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e flex 
¥
6
$
e fixed  7
$
QDfixed
 12
$
QSfixed
 20
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To simplify the notation notice we denote the value of the dollar by e with a subscript to
distinguish between fixed and flexible exchange rates. It is also worth mentioning that
$
$
since the fixed value of the dollar is by assumption higher than the flexible one.
QSfixed
 QDfixed
To find the parameters that yield these numbers it is useful to formally characterize both
the flexible equilibrium and fixed exchange rate solutions. For flexible exchange rates, the
$
$
equilibrium condition is simply that QSflex
 QDflex
 Q$flex , i.e., equation (3) is set equal to equation
(6) which yields
1
e flex
 a  n$ n¥ 1
 $ 
 a¥ 
(9)
and equivalently
n¥ 1
n$
Q$ flex   a$  n$ n¥ 1  a¥  n$ n¥ 1 .
(10)
The fixed exchange rate case is even simpler. The supply of dollars is taken directly from (3)
$
QSfixed
 e fixed 
1 n¥
 a¥
(11)
$
QDfixed
 e fixed   a$ .
(12)
and the demand for dollars from (5)
n$
With these equations we can tackle what, for lack of a better term, we will call the
technical problem—the opposite in some sense of the economic one. The economic problem is
$
$
to find {Q$flex , e flex } and {QDfixed
, QSfixed
} for a given e fixed and given values of {a$ , a¥ , n$ , n¥ } . The
technical problem is the reverse. To find values of {a$ , a¥ , n$ , n¥ } that will yield the (chosen by
$
$
the instructor) values of {Q$flex , e flex , QDfixed
, QSfixed
, e fixed } for our example, the values in Table 3.
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$
$
Notice that in equations (9)-(12) the set {Q$flex , e flex , QDfixed
, QSfixed
, e fixed } are on the left-hand
side and the {a$ , a¥ , n$ , n¥ } are on the right-hand side, except that in (11) and (12) the fixed
exchange rate has an exponent related to the elasticity.
It is computationally simpler now to use the log transformed versions of (9)-(12), which
are respectively
Log[e flex ] n$  n¥  1  Log[a$ ]  Log[a¥ ]
(13)
Log[Q$ flex ](n$  n¥  1)  (n¥  1) Log[a$ ]  n$ Log[a¥ ]
(14)
$
Log[ QSfixed
]  (n¥ 1) Log[e fixed ]  Log[a¥ ]
(15)
$
Log[QDfixed
]  n$ Log[e fixed ]  Log[a$ ].
(16)
As a final step just to clarify the notation, define A$  Log[a$ ] A¥  Log[a¥ ] , next define
$
r  Log[e flex ] s  Log[e fixed ] , and finally x  Log[QDfixed
] , y  Log[Q$ flex ] , and
$
z  Log[ QSfixed
]
.
So rewriting (13)-(16) again with this notation yields
r  n$  n¥ 1  A$  A¥
(17)
y(n$  n¥  1)  (n¥  1) A$  n$ A¥
(18)
z  (n¥  1) s  A¥
(19)
x  n$ s  A$ .
(20)
Solving these for {n$ , n¥ , A$ , A¥ } is straight forward.
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A$ 
$
sy  rx Log[e fixed ]Log[Q$ flex ]  Log[e flex ]Log[QDfixed ]

sr
Log[e fixed ]  Log[e flex ]
(21)
A¥ 
$
sy  rz Log[e fixed ]Log[Q$ flex ]  Log[e flex ]Log[ QSfixed ]

sr
Log[e fixed ]  Log[e flex ]
(22)
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$
y  x Log[Q$ flex ]  Log[QDfixed ]
n$ 

sr
Log[e fixed ]  Log[e flex ]
(23)
Log[ QSfixed ]  Log[Q$ flex ]
zy
n¥  1 
 1
.
sr
Log[e fixed ]  Log[e flex ]
(24)
$
Given that these are logs they can be written in several equivalent ways, and it must be
remembered that A$  Log[a$ ] and A¥  Log[a¥ ] i.e., that a$  Exp[ A$ ] and a¥  Exp[ A¥ ] . So
to complete the example used for Tables 1-3 and Figures 1 and 2, a$  200.686 , a¥  0.530 ,
n$  1.448 , and n¥  2.866 .
Now the work to construct as many examples as needed has been completed. To mention
just a couple possibilities, if the goal is to have very transparent exchange rates and trading
volumes, then
{a$  125, a¥  125, n$  1.322, n¥  1.262}
(25)
will be generated by
{Q$flex  125, e
flex
$
$
 1, QDfixed
 50, QSfixed
 150, e fixed  2}.
(26)
If the goal is to construct an example where the dollar is undervalued, then
{a$  150, a¥  50, n$  1.322, n¥  1.263}
(27)
will be generated by
{Q$flex  60, e
flex
$
$
 1, QDfixed
 150, QSfixed
 50, e fixed  2}.
(28)
These examples are simplified by the fact that one of the exchange rates is one, the log of one
being zero, the constants are easy to compute, and the elasticities virtually the same.
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CONCLUSION
As every student of economics knows the end of the Bretton Woods foreign exchange
rate system did not necessarily spell the end of fixed exchange rates. Various countries, notably
South Korea, Japan, and China, have found it to their economic advantage to manipulate
exchange rates in their favor. Maintaining an undervalued currency has been (at various times
during the past forty years) a critical component of their respective export-led growth strategies.
However, to keep your currency from revaluation requires selling your currency and buying the
foreign currency. The result is an accumulation of foreign reserves.
Our goal in this paper has been to present a technique that facilitates more easily and
intuitively the teaching of exchange rates and the important consequences of currency
manipulation. The latter requires buying and selling vast quantities of currencies in the foreign
exchange market. Our model focuses attention squarely on these trading volumes and allows the
student to literally see that maintaining an undervalued currency leads directly to the stockpiling
of foreign reserves. Since generating realistic numerical examples using our preferred isoelastic
demand curves would not be every instructors best use of scarce time, we have provided a
technique for generating these numerical examples. Using our “currency offer curves” pedagogy
will hopefully take some of the mystery out of the not-so-rare practice of maintaining exchange
rates different from equilibrium. While Korea and Japan have transitioned off the dollar peg and
China may eventually do so as well, examples of emerging economies following their lead will
surely not disappear any time soon.
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REFERENCES
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Calvo, G. A., & Reinhart, C. M. (2002). Fear of Floating. Quarterly Journal of Economics,
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Global Finance. (2012). International Reserves of Countries Worldwide.
http://www.gfmag.com/tools/global-database/economic-data/11859-internationalreserves-by-country.html#axzz22sNNJDLY
Highfill, J., & Wojcikewych, R. (2012). A Note on Teaching the Yuan-Dollar Market vis-a-vis
China’s Dollar Holdings. Global Economy Journal,12(1), article 7.
Highfill, J., & Wojcikewych, R. (2011). The U.S.-China Exchange Rate Debate: Using
Currency Offer Curves. International Advances in Economic Research, 17(4), 386-396.
International Monetary Fund. (2005.) IMF Annual Report 2005. Washington DC.
Ito, T. (2006). Robust Monetary Framework for China. China and World Economy, 14(5), 32-47.
Krugman, P. (2011, October 3). Holding China to Account. New York Times,
http://www.nytimes.com/2011/10/03/opinion/holding-china-to-account.html?_r=1.
Obstfeld, M. (2007). The Renminbi’s Dollar Peg at the Crossroads. Monetary And Economic
Studies, 25(S1), 29-55.
The Economist . (2012, May 26). Prudence Without a Purpose. 403(8786), 8-11.
The Economist . (2012, May 26). The Retreat of the Monster Surplus. 403(8786), 5.
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2013 Cambridge Business & Economics Conference
ISBN : 9780974211428
APPENDIX: LINEAR DEMAND FOR DOLLARS
The goal of this appendix is to give a very brief example of what the supply of yuan
curve looks like if the demand for dollars is linear. Suppose the demand for dollar function is
¥
 15  QD$
$
(29)
as shown in Figure 3.
July 2-3, 2013
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2013 Cambridge Business & Economics Conference
¥
$
ISBN : 9780974211428
Value of Dollar
14
12
10
8
6
4
D$
2
2
4
6
8
10
12
14
Dollars
Figure 3: Linear Demand for Dollars
July 2-3, 2013
Cambridge, UK
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2013 Cambridge Business & Economics Conference
ISBN : 9780974211428
The equivalent supply of yuan is
2
¥
$ 15  15  4QS

¥
2QS¥
(30)
as shown in Figure 4.
$
¥
Value of Yuan
1.5
1.0
0.5
S¥
10
20
30
40
50
Yuan
Figure 4: Supply of yuan derived from linear demand for dollars
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