Exchange Rate Policy Fixed or Floating?

Fixed Exchange Rate Regime

Fixed Exchange Rate Regime Ways to keep exchange rates at the desired (fixed) rate: Exchange market intervention Government purchases or sales of currency in the foreign exchange market What actions would cause what effects? Change in monetary policy a. What changes would cause what effects? Foreign exchange controls Licensing systems that limit the right of individuals to buy foreign currency --What types of controls would cause what types of effects?

Floating or Fixed? What To Do? PROS OF A FIXED EXCHANGE RATE REGIME: Reduces transaction costs by reduction of uncertainty (the value is fixed) Commits countries to policies that avoid destructive inflationary economic policies CONS OF A FIXED EXCHANGE RATE REGIME : Countries must have large quantities of foreign currency on hand (low-return investment) --Even large reserves can be quickly exhausted Monetary policy may become tied to foreign exchange goals, rather than economic stabilization Foreign exchange controls (e.g. import quotas or tariffs) can distort markets Can cause opportunities for waste (bureaucratic red tape) and corruption.

Problems Suppose the U.S. and Mexico are the only two countries in the world: Draw a correctly labeled graph of the foreign exchange market for U.S. dollars showing the equilibrium in the market (the currency in Mexico is the peso). On your graph, indicate a fixed exchange rate below the equilibrium exchange rate. Does the fixed exchange rate lead to a surplus or shortage of U.S. dollars? Explain and show the amount of surplus/shortage on your graph. To bring the foreign exchange market back to equilibrium at the fixed exchange rate, would the U.S. government need to buy or sell dollars? On your graph, illustrate how the government buying or selling dollars would bring the equilibrium exchange rate back to the desired fixed rate. Suppose that instead of buying or selling dollars, the Federal Reserve was going to engage in monetary policy to bring the foreign exchange market back to equilibrium a the fixed exchange rate. What would the Fed most likely do to accomplish this?

Problems 2. Draw a diagram of a foreign exchange market where China is keeping the exchange rate fixed at a target rate BELOW equilibrium. Show with a diagram for EACH the changes below: China allows the exchange rate to float. China places restrictions on foreigners who want to invest in China. China removes restrictions on Chinese who want to invest abroad. China imposes taxes on Chinese exports, such as clothing.