[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Exchange Rate Management
Fluctuations in exchange rate can have important effects on an economy. As a country’s
currency appreciates, its exports become more expensive for foreign buyers,
causing declines in production and employment in export-producing industries.
Many developing countries have foreign debts that must be repaid in dollars.
Depreciation in their currency will make buying the dollars to repay their debt more
expensive, increasing its burden. Because of the link between interest rates and
exchange rates, central banks in many countries have attempted to use their influence
over interest rates to “manage” the exchange rate. In some cases, they have
simply tried to smooth out day-to-day fluctuations in the foreign exchange market.
In others, they have tried to permanently move the exchange rate higher or lower.
There are two extremes of this continuum. At one pole, countries have flexible
exchange rates that move in response to fluctuations in demand and supply; they
do not intervene directly in the foreign exchange market. At the other pole, countries
fix their exchange rates, announcing a value and then intervening in the foreign
exchange market to keep the exchange rate at that level.
EXCHANGE RATE = U.S. DOLLAR/PESO (e)
e f
e*
Figure 34.5
PESOS
Supply
of pesos
Demand
for pesos
GOVERNMENT INTERVENTION IN A FIXED
EXCHANGE RATE SYSTEM
Demand for pesos
with government
intervention
If the “fixed” value for the dollar-peso exchange rate under the
fixed exchange rate system, e f , differs from the market equilibrium
rate, e*, then sustaining the fixed exchange rate requires
government intervention. When e f is above e*, the government
enters the foreign exchange market demanding pesos (supplying
dollars or other foreign currencies) until the equilibrium
exchange rate is equal to the pegged rate e f .
Fixed Exchange Rate Systems The United States has
had a flexible exchange rate for more than three decades. Before
1971, the world had a fixed exchange rate system: that is,
exchange rates were pegged at a particular level. Thus the U.S.
dollar was pegged to gold, valued at $32 per ounce, while other
currencies were fixed in terms of the dollar. Exchange rates
changed only as the result of explicit government decisions.
Before the euro was introduced as the common currency of the
European Economic and Monetary Union, the member countries
of the union permanently fixed the exchange rates between
their currencies. Often smaller countries will decide to fix their
exchange rate relative to an important trading partner. Estonia’s
exchange rate, for example, is fixed in terms of the euro. From
this brief description, three questions follow: How does a country
“fix” its exchange rate? What are the consequences of fixed
exchange rates for monetary policy? And what are the pros and
cons of a fixed exchange rate system?
Fixing the Exchange Rate Let’s suppose the government
of Mexico has decided to fix the exchange rate between the peso
and the dollar at 9 pesos to the dollar; this was approximately the
peso-dollar exchange rate in 1998. Figure 34.5 depicts the foreign
exchange market for pesos. It is important to note that we
have drawn the figure to represent the market for pesos, so the
quantity on the horizontal axis is expressed in terms of pesos
and the exchange rate is dollars per peso. (Our earlier figures
focused instead on the dollar exchange rate; the quantity
along the horizontal axis was dollars, and the vertical axis was
766 ∂ CHAPTER 34 THE INTERNATIONAL FINANCIAL SYSTEM