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Module 43 Exchange Rate Policy KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson
What you will learn in this Module: • The difference between fixed exchange rates and floating exchange rates • Considerations that lead countries to choose different exchange rate regimes
Exchange Rate Policy A nation can deliberately manipulate the exchange rate of its won currency to achieve certain economic goals. WHY would they do this? The exchange rate has a great deal of influence on net exports. If your nation’s currency is inexpensive 1. foreigners will find your goods to be inexpensive 2. Your net exports will rise to your GDP will rise.
Exchange Rate Regimes • Exchange Rate Regime – a rule governing policy towards the exchange rate. • Fixed Exchange Rate – the government keeps the exchange rate against another currency at/near a particular target. • Floating Exchange Rate – the government lets the exchange rate go wherever the market takes it. (US, Britain, Canada follow this policy)
How Can an Exchange Rate Be Held Fixed? Suppose the small nation of Highlander Decides to fix their currency, the Lander, At a rate of $2 US for every 1 Lander. If the Lander is exchanged in a free market, The equilibrium exchange rate maybe higher, Or lower, than the target rate of $2.
How Can an Exchange Rate Be Held Fixed? Exchange Rate ($/Lander) The Equilibrium Exchange Rate is Below $2 S Landers 2% Surplus of Landers 1% D Landers Q Landers The Highlander government can: 1. Buy up the surplus of Landers in the FOREX. This is called Exchange Market Intervention. 2. The Central Bank of Highlander can increase interest rates. 1. Attract foreign capital investment 2. Increasing D Lander 3. Reduce capital outflow from Highlander 4. Reduce S Lander 5. P of Lander will rise. 1. Limit the right of individuals to buy foreign currency. 1. S Landers reduced 2. P of Lander will rise.
How Can an Exchange Rate Be Held Fixed? Exchange Rate ($/Lander) The Equilibrium Exchange Rate is Above $2 S Landers 3% 2% Shortage of Landers D Landers Q Landers The Highlander government can: 1. Sell Landers in the FOREX. This is called Exchange Market Intervention. 2. The Central Bank of Highlander can decrease interest rates. 1. Deter foreign capital investment 2. Decreasing D Lander 3. Increase capital outflow from Highlander 4. increase S Lander 5. P of Lander will fall. 1. Limit the ability of foreigners to buy the Lander. 1. S Landers increased. 2. P of Lander will fall.
The Exchange Rate Regime Dilemma Is it a good idea to fix the exchange rate? • The Case for Fixed Exchange Rates • Facilitates trade by creating certainty about the exchange rate – the value of your currency stays the same. • Acts as a check on inflationary policies • No dramatic increase in money supply
The Exchange Rate Regime Dilemma • The Case against Fixed Exchange Rates • Requires large foreign currency reserves • May divert monetary policy • Distorts incentives • Opportunity for corruption