Brief answers to problems and questions for review
1. An inconvertible currency is one that cannot be freely traded for another country’s
currency among domestic consumers and businesses. Under this system, the government
or the central bank becomes a monopolist with respect to holding all foreign exchange
and all residents and firms of the country are legally obligated to sell any foreign
exchange to the government at a fixed price. Likewise, any resident or firm that needs
foreign exchange must purchase it from the government at the same fixed price.
2. Under a system of exchange controls, it becomes relatively easy for the government to
“fix” the price of foreign exchange. This exchange-rate system almost always requires the
government to seriously control the flow of capital into and out of the country.
3. As a practical matter, exchange controls tend to cause a number of economic difficulties.
First, there is the simple annoyance of dealing with a government bureaucracy. The
government must sell or buy all foreign exchange earned and requested by residents and
firms within the country. A more serious difficulty arises with respect to the difference
between the nominal exchange rate and the real exchange rate. When a country fixes the
exchange rate, this usually means that the exchange rate is fixed in nominal terms. So
long as the nominal exchange rate is close to its purchasing power parity value, then a
nominal peg may be sustainable over time. A common problem in this regard is that a
country’s domestic inflation may not be equal to the foreign rate of inflation. In this case,
the country’s real exchange rate is depreciating and the nominal exchange rate is
becoming overvalued. To balance the demand for foreign exchange with the supply of
foreign exchange, the government can use one of three options. First, the government
could allow the currency to depreciate. Second, the government could implement
restrictive macroeconomic policies (contractionary fiscal and/or monetary policy) that
would reduce the demand for foreign exchange. The third and most common option
available to the government is to ration the available supply of foreign exchange in the
domestic markets.
4. Figure 18.2 shows how an inconvertible currency could lead to a shortage of foreign
exchange. The demand and supply of foreign exchange would only balance at E. If the
demand for foreign exchange increases at all from D, then there is going to be a shortage
of foreign exchange at the fixed exchange rate, XRe.
5. Intervention in the foreign exchange market occurs when the government or the central
bank tries to change the supply of foreign exchange in order to influence the exchange
rate. If the government buys foreign exchange this would shift the supply curve to the left
and tend to cause a depreciation of the exchange rate. If the government sells foreign
exchange this would tend to shift the supply curve to the right and cause an appreciation
of the exchange rate.
6. Many countries “fix” their currency to the currency of another country using intervention
in the foreign exchange market. Intervention simply refers to the government buying and
selling foreign exchange to influence the value of the exchange rate. A country’s central
bank usually conducts intervention in the foreign exchange market. The government can
maintain the exchange rate in the short run by either selling or buying foreign exchange.
In the long run, the country can maintain the exchange rate so long as it can sell or buy
foreign exchange. In theory, a country can buy foreign exchange (sell domestic currency)
© 2015 W. Charles Sawyer and Richard L. Sprinkle
forever and keep its exchange rate from appreciating. However, a country can only sell
foreign exchange for a limited period of time before it runs out of foreign exchange. In
order for a country to maintain the “fixed” exchange rate over time, internal balance must
be adjusted to be consistent with the fixed exchange rate. In this case, the government
intervention has two major effects. First, in the short run the government intervention
stabilizes the exchange rate. Second, the intervention has set into motion an automatic
adjustment process that virtually guarantees that the private sector balance of payments
deficit will not persist in the long run. The government intervention causes the domestic
money supply to fall. As the money supply falls, aggregate demand also falls and the
equilibrium levels of output and the price level both decline. As this occurs, the
government’s need to intervene in the foreign-exchange market would also diminish. In
this case, the government has maintained the fixed exchange rate by reducing the
equilibrium level of output or the rate of economic growth. A fixed exchange rate
arrangement has the advantage of not only “fixing” the exchange rate, but it also
automatically adjusts the economy to a sustainable external equilibrium. Maintaining a
fixed exchange rate through intervention means that a country cannot use discretionary
monetary policy to influence the economy. This loss of monetary policy occurs because
in order to maintain a fixed exchange rate, the monetary base and the money supply
become a function of the country’s external balance.
7. A current account deficit would cause a leftward shift of the aggregate demand curve that
could contribute to a recession. With a fixed exchange rate, it might be necessary for the
government to sell foreign exchange in order to maintain the exchange rate. This sort of
intervention could lead to a falling money supply as the selling of foreign exchange leads
to the withdrawal of domestic currency from the banking system. A falling money supply
would definitely lower aggregate demand.
8. A current account surplus and a fixed exchange rate would lead to the buying of foreign
exchange. This buying of foreign exchange would mean an injection of money into the
domestic banking system that could lead to an expansion of the money supply. These
factors would lead to a significant increase in aggregate demand that might put severe
upward pressure on the price level (P).
9. Under a fixed exchange-rate system, there are two cases where monetary policy is
consistent with both internal and external balance. For example, if an external deficit
occurs when the economy has inflation, the response of monetary policy (contraction of
the money supply) that automatically occurs will move the economy towards full
employment and lower inflation. Also, if an external surplus occurs when the economy is
at less than full employment, the response of monetary policy (expansion of the money
supply) that automatically occurs will move the economy closer to full employment.
10. Under a fixed exchange-rate system, there are two cases that require the country to
sacrifice the interests of internal balance in order to maintain the country’s external
balance. For example, if an external deficit occurs when the economy is at less than full
employment, the response of monetary policy (contraction of the money supply) that
automatically occurs will move the economy further away from full employment. In this
situation, the automatic adjustment requires the country to suffer a recession to maintain
the fixed exchange rate. Also, if a country has an external surplus coupled with a period
of inflation or a rapid period of economic growth, the response of monetary policy
© 2015 W. Charles Sawyer and Richard L. Sprinkle
(expansion of the money supply) that automatically occurs will move the economy to
even higher inflation or even more rapid economic growth.
11. The effects of expansionary fiscal policy lead to a government budget deficit that must be
financed. In this case, the government’s extra borrowing causes interest rates to rise. In an
open economy with freely flowing international capital, the rise in interest rates causes an
inflow of foreign capital. As foreign capital moves into the domestic market, the supply
of loanable funds is augmented by foreign capital. The inflow of foreign capital lowers
interest rates. When the government adopts an expansionary fiscal policy, the inflow of
foreign capital requires that foreign investors first sell foreign currency (i.e., buy domestic
currency). The effect of the capital flows is clear. In this case, the government must
intervene in the foreign-exchange market and buy foreign currency. This intervention in
the foreign exchange market maintains the “fixed” or “pegged” exchange rate. The
secondary effect of the government intervention is that the money supply changes. In this
case, when the government buys foreign exchange it also sells currency and the money
supply increases. The effect of the increase in the money supply is to increase the amount
of loanable funds available and interest rates decline. Also, as the government adopts an
expansionary fiscal policy, aggregate demand increases. The initial effect of this
expansionary fiscal policy is to increase both domestic output and the price level. In
addition to this initial effect, the intervention in the foreign exchange market and the
resulting increase in the money supply cause aggregate demand to increase even further.
The net result is that in an open economy with capital mobility and fixed exchange rates,
the effects of expansionary fiscal policy are more pronounced.
12. Fiscal policy is effective in achieving internal balance when the exchange rate is fixed
because as the government adopts an expansionary fiscal policy, aggregate demand
increases. The initial effect of this expansionary fiscal policy is to increase both domestic
output and the price level. In addition to this initial effect, the intervention in the foreign
exchange market and the resulting increase in the money supply causes aggregate demand
to increase even further. The net result is that in an open economy with capital mobility
and fixed exchange rates, the effects of expansionary fiscal policy are more pronounced.
13. Technically, it is possible to separate monetary policy from intervention in the foreign
exchange market. This separation is known as sterilization. For example, if the
government is selling foreign exchange (international reserves) to maintain the exchange
rate, this causes a decrease in the monetary base and the money supply. A government
(central bank) can easily offset this effect through open market operations. The
government knows exactly how much the intervention has reduced the monetary base,
i.e., the government knows how much foreign currency it sold and how much domestic
currency it bought in the foreign exchange market. In response to this intervention, the
government could conduct open market operations in the domestic bond market by
purchasing a like amount of bonds. The intervention in the foreign exchange market
reduces the monetary base. However, this reduction in the monetary base can be sterilized
by purchasing the equivalent amount of bonds. The net effect of intervention and
sterilization on the domestic supply of money is therefore zero. In this way a government
can keep the domestic money supply insulated from the intervention in the foreign
exchange market.
14. Sterilization works best when the intervention in the foreign exchange market is used to
correct relatively small deviations from purchasing power parity. In this case
© 2015 W. Charles Sawyer and Richard L. Sprinkle
interventions are sufficiently small that the exchange rate policy will not badly distort the
focus of monetary policy on the price level and real GDP.
15. If a country has a high rate of inflation then the amount of intervention necessary to fix
the exchange rate may be large. If the constant selling of foreign exchange is sterilized,
then the money supply will not fall and neither will the rate of inflation. This policy can
continue only so long as the government has access to foreign exchange. If the supply of
foreign exchange for intervention is interrupted, then the intervention would cease and the
exchange rate would rapidly depreciate.
16. A useful variation on a fixed exchange rate is to fix (peg) the real exchange rate. In this
case the nominal exchange rate would be allowed to change fairly frequently. What is
held constant is the real exchange rate. The common term for this system is a crawling
peg. The difficulty with maintaining an exchange rate that is pegged in nominal terms is
that it requires that the ratio of changes in domestic prices to changes in foreign prices be
constant. The difficulty with a pegged nominal exchange rate is that the real exchange
rate may be fluctuating. A preferable policy with respect to the exchange rate is to peg the
exchange rate in real terms. In practice, the country may set a preannounced rate of
change in the nominal exchange rate based on inflation rate differences. Although
participants in the foreign exchange market are facing an exchange rate that is changing,
the amount of change is known in advance. Usually, the rate is changed on a
preannounced schedule such as daily or weekly. Even though the nominal exchange rate
is changing, the real exchange rate is being held steady.
17. In some cases, a country may be willing to sacrifice domestic monetary policy in the
interest of maintaining a fixed exchange rate. Suppose that two countries trade
extensively with one another because of a combination of location, language, and
similarity of business environments. In addition, if the relationship is truly close, then the
correlation between changes in the GDPs of the two countries may be rather high. In
many cases, this occurs because one country’s GDP may be substantially larger than the
other. In these circumstances, the smaller country might choose to fix its exchange rate in
nominal terms to the currency of the larger country. Citizens in both countries benefit
from the security of a fixed exchange rate that makes trade and investment less risky as a
fixed exchange rate eliminates exchange rate risk. The smaller country’s monetary policy
may have to be sacrificed to keep the exchange rate fixed. The smaller country will have
a growth rate of the money supply and an inflation rate that is nearly identical to that of
the larger country.
18. There are a number of benefits and costs associated with a currency union. A benefit of a
currency union is the monetary efficiency gain. Monetary efficiency gains are the gains
that are derived from not having to change currencies in order to buy or sell goods or
services across national borders. A cost of a currency union is the loss of an autonomous
monetary policy. If either country wished to pursue an independent monetary policy, it
could not do so with a currency union. Whether or not a currency union is a good idea
depends on the magnitude of the monetary efficiency gains versus the potential losses in
terms of economic stability. A country’s monetary efficiency gains are influenced by a
number of factors. The greater the amount of trade between the countries, the larger the
monetary efficiency gains will be. However, there is not some type of precise cutoff point
where a currency union is a good idea on one side and not a good idea on the other. The
gains of a monetary union can be extrapolated to the movement of factors of production
© 2015 W. Charles Sawyer and Richard L. Sprinkle
between the countries joining the union. If capital is mobile between countries there will
be additional gains for both currency traders and investors. Likewise, there are several
factors that influence the losses in terms of economic stability of each of the countries
joining the union. If labor can (and most importantly does) freely migrate between the
countries the losses associated with economic stability are reduced. Second, the more
similar the two countries’ average rates of inflation, the smaller the economic stability
losses in both countries. Third, the economic stability losses are smaller if there is some
form of common fiscal policy within the countries joining the union. The final factor is
the most important in determining the size of the economic stability losses. The economic
stability losses will be smaller the higher the correlation of GDP between the two
countries.
19. There are three conditions for an optimum currency area. First, there needs to be a
substantial amount of trade. Second, a currency area will work better if there is free
mobility of resources. Third, a currency union works best if there is a high correlation in
economic conditions across the region. In the case of the United States, the first two
conditions are obviously met. The third condition is more questionable as all regions of
the US do not grow at the same rate at all times.
20. If the exchange rate is fixed and capital is mobile, monetary policy is not effective. If the
exchange rate floats and capital is mobile, monetary policy is effective. A country can
accomplish two out of the three but not all three together.
© 2015 W. Charles Sawyer and Richard L. Sprinkle