Exchange Rate Economics: Theories and Evidence

Introduction 9
S
S 1
S 0
SS
B
A
C
DD9
DD
FX 0 FX 1
Quantity of foreign exchange
Figure 1.1 The balance of payments model of the determination of the exchange
rates.
present in Figure 1.1 a portrait of this determination of the exchange rate,which
is set-up with the US as the home country and Japan as the foreign country.
Thus underlying DD is the US’s demand of imports of goods and services which
depends upon the normal factors (on the import demand side consumers’ income
and tastes,and on the import supply side foreign producers’ factor prices). The
demand schedule for foreign exchange is downward sloping for the familiar reason
that from a position of equilibrium (on the demand curve),an increased quantity
of foreign exchange will only be demanded at a lower price. (Note that all of
this discussion is from the point of view of the US as the home country.) The
exchange rate is determined by the intersection of the demand and supply curves
at S 0 ,with an equilibrium quantity of foreign exchange,FX 0 . An increase in the
demand for dollars,as a result,say,of a change in tastes or increased income
in the US,would shift the demand curve to DD ′ . At the initial equilibrium at
A there would be an excess demand for yen,putting upward pressure on their
price,which,in turn,leads to quantity changes until equilibrium is restored at
S 1 /FX 1 . It is worth noting this positive association between income and the
exchange rate since,as we shall see in future chapters,it sharply contrasts with the
modern asset view of the determination of the exchange rate.
Clearly,in terms of the earlier example,if the exchange rate was not flexible but
pegged,as in the Bretton Woods system,the monetary authorities would be forced
to intervene in the foreign exchange market to prevent the exchange rate from
rising. For example,if in Figure 1.1 we now assume the exchange rate is fixed
at S 0 ,and therefore the central bank has a commitment to buy and sell foreign
exchange at this price to defend the currency. With the same change in demand
as before,we now have excess demand for foreign exchange at the fixed rate and