1. Module Exchange Rate Policy43
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson

2. 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

3. 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.
As we have seen in the previous module, the nominal exchange rate is a price that is determined by supply and demand in a market.
This is very similar to how the price of apples or soybeans might be set by market forces.
However, a nation can deliberately manipulate the exchange rate of its own currency to achieve certain economic goals.
Why? Because the exchange rate has a great deal of influence on net exports. If your nation’s currency is inexpensive, foreigners will find your goods to be inexpensive and your net exports will rise.

4. 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)
An exchange rate regime is a rule governing policy toward the exchange rate.
There are two main kinds of exchange rate regimes.
A country has a fixed exchange rate when the government keeps the exchange rate against some other currency at or near a particular target. For example, Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$1.
A country has a floating exchange rate when the government lets the exchange rate go wherever the market takes it. This is the policy followed by Britain, Canada, and the United States.
But if the exchange rate is determined by market forces of supply and demand, how can it be held fixed?

5. How Can an Exchange Rate Be Held Fixed?
Suppose the China decides to fix their currency, the Yuan, at a rate of $1 US for every 8 Yuan.
If the Yuan is exchanged in a free market, the equilibrium exchange rate may be higher, or lower, than the target rate of $1.
The government of China can:
Buy up the surplus of Yuan in the foreign exchange market. This is called exchange market intervention. The government must have dollars for this purchase, which is why governments keep foreign exchange reserves, or stocks of foreign currencies, so that they can engage in these types of price supports.
The government can try to shift either the demand or supply curves so that the price rises to the target of $1. Maybe Chinese policymakers can increase interest rates. This will attract foreign capital investment, increasing the demand for the yuan.This will also reduce the capital outflow from China, reducing the supply of yuan. The price of the yuane will begin to rise.
The government can limit the right of individuals to buy foreign currency. The government might require citizens to acquire a license to purchase dollars, thus reducing the supply of the yuan. The price will begin to rise.
Sell yuan in the foreign exchange market.
The Chinese policymakers can decrease interest rates. This will deter foreign capital investment, decreasing the demand for the yuan. This will also increase the capital outflow from China, increasing the supply of yuan. The price of the yuan will begin to fall.
The government can limit the ability of foreigners to buy the yuan. The price will begin to fall.
But is it actually a good idea to fix the exchange rate?
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.

6. How Can an Exchange Rate Be Held Fixed?
Exchange Rate ($/Lander)
The Equilibrium Exchange Rate is Below $2
The Highlander government can:
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.
Attract foreign capital investment
Increasing D Lander
Reduce capital outflow from Highlander
Reduce S Lander
P of Lander will rise.
Limit the right of individuals to buy foreign currency.
S Landers reduced
What determines whether money flows into a nation’s financial account?
The financial account is a measure of capital inflows, of foreign savings that are available to finance domestic investment spending.
The basic model of the loanable funds market is used to model the flow of financial capital from one nation to another.
In using this model, we make two important simplifications:
We simplify the reality of international capital flows by assuming that all flows are in the form of loans. In reality, capital flows take many forms, including purchases of shares of stock in foreign companies and foreign real estate as well as direct foreign investment, in which companies build factories or acquire other productive assets abroad.
We also ignore the effects of expected changes in exchange rates, the relative values of different national currencies. We analyze the determination of exchange rates later.
Note: the instructor can pick any two nations to use as an example. And this example can also be used as the in-class activity below.
Suppose that the real interest rate in the US is 3% and the real interest rate in Japan is 7%.
Note: this is a good opportunity for students to review the LF market. Ask them to draw two side-by-side markets and show how the real interest rate in Japan is significantly higher.
When two nations have differing real interest rates in their domestic loanable funds markets, savers in the U.S. begin to look for countries like Japan where the return on a financial asset is higher.
Individuals and firms in the U.S. begin to purchase financial assets in Japan, sending dollars as payment to Japan.
Another way to think about it is that the US is exporting dollars and importing financial assets. Japan is exporting the financial assets and importing dollars.
Note: stress to the students that recent AP Macro exams have been very strict on this point. It is important that students understand that U.S. investors are seeking financial assets in Japan, not physical assets (like factories) in Japan.
These dollars serve as capital inflow in Japan, and capital outflow from the U.S. The flow of dollars ends when the interest rate disparity is gone, perhaps at a level of about 5%.
S Landers
Surplus of
Landers 2% 1%
D Landers
Q Landers

7. How Can an Exchange Rate Be Held Fixed?
Exchange Rate ($/Lander)
The Equilibrium Exchange Rate is Above $2
The Highlander government can:
Sell Landers in the FOREX. This is called
Exchange Market Intervention.
2. The Central Bank of Highlander can decrease interest rates.
Deter foreign capital investment
Decreasing D Lander
Increase capital outflow from Highlander
increase S Lander
P of Lander will fall.
Limit the ability of foreigners to buy the Lander.
S Landers increased.
What determines whether money flows into a nation’s financial account?
The financial account is a measure of capital inflows, of foreign savings that are available to finance domestic investment spending.
The basic model of the loanable funds market is used to model the flow of financial capital from one nation to another.
In using this model, we make two important simplifications:
We simplify the reality of international capital flows by assuming that all flows are in the form of loans. In reality, capital flows take many forms, including purchases of shares of stock in foreign companies and foreign real estate as well as direct foreign investment, in which companies build factories or acquire other productive assets abroad.
We also ignore the effects of expected changes in exchange rates, the relative values of different national currencies. We analyze the determination of exchange rates later.
Note: the instructor can pick any two nations to use as an example. And this example can also be used as the in-class activity below.
Suppose that the real interest rate in the US is 3% and the real interest rate in Japan is 7%.
Note: this is a good opportunity for students to review the LF market. Ask them to draw two side-by-side markets and show how the real interest rate in Japan is significantly higher.
When two nations have differing real interest rates in their domestic loanable funds markets, savers in the U.S. begin to look for countries like Japan where the return on a financial asset is higher.
Individuals and firms in the U.S. begin to purchase financial assets in Japan, sending dollars as payment to Japan.
Another way to think about it is that the US is exporting dollars and importing financial assets. Japan is exporting the financial assets and importing dollars.
Note: stress to the students that recent AP Macro exams have been very strict on this point. It is important that students understand that U.S. investors are seeking financial assets in Japan, not physical assets (like factories) in Japan.
These dollars serve as capital inflow in Japan, and capital outflow from the U.S. The flow of dollars ends when the interest rate disparity is gone, perhaps at a level of about 5%.
S Landers 3% 2%
Shortage of
Landers
D Landers
Q Landers

8. 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
There are advantages and disadvantages of both the fixed and floating exchange rate regimes.
Advantages in Stability
A fixed exchange rate provides stability in foreign transactions in much the same way we experience transactions across state lines.
If you take your dollars from Indiana to Kentucky, you know that the value of your dollars is unchanged.
But if you take your dollars from Indiana to Europe, the value of those dollars can change daily. A fixed exchange rate avoids this uncertainty.
The fixed exchange rate also commits the central bank to monetary policies that would not upset the exchange rate. For example, if the bank adhered to the exchange rate regime, the bank could not dramatically increase the money supply. This would cause inflation and reduce the value of the currency. More stability.

9. The Exchange Rate Regime Dilemma
Disadvantages in Costs
To stabilize an exchange rate through intervention, a country must keep large quantities of foreign currency on hand, and that currency is usually a low­-­return investment.
Even large reserves can be quickly exhausted when there are large capital flows out of a country.
If a country chooses to stabilize an exchange rate by adjusting monetary policy rather than through intervention, it must divert monetary policy from other goals, notably stabilizing the economy and managing the inflation rate.
Finally, foreign exchange controls, like import quotas and tariffs, distort incentives for importing and exporting goods and services. They can also create substantial costs in terms of red tape and corruption
The Case against Fixed Exchange Rates
Requires large foreign currency reserves
May divert monetary policy
Distorts incentives
Opportunity for corruption