Market Adjustment to Changes in Money Market Conditions By modifying exchange rates to correct for imbalances in payments, the money market can accommodate vast changes in the economic c
Trang 1Market Adjustment to Changes in Money Market Conditions
By modifying exchange rates to correct for imbalances in payments, the money market
can accommodate vast changes in the economic conditions of nations engaged in trade
A good example is the way the market handles a change in consumption patterns These changes in consumption, and hence in foreign exchange rates, can be caused by changes
in a nation’s tastes and preferences, real income, level of prices (including interest rates), costs, and expectations as to future exchange rates If all countries’ exchange rates move with the relative rates of inflation, only real (terms of trade) changes would affect the
relative prices of home country to foreign-country goods However, while floating
exchange rates tend to eliminate automatically any balance-of-payment problems, they
may diminish the volume of trade because of the uncertainty and instability of the terms
of trade In fact, since flexible exchange rates were reintroduced in 1971 the volume of
world trade has actually grown despite considerable volatility and turbulence
The two major advantages of a floating system are that exchange rates are
automatically determined exclusively by free market forces, without government
intervention, controls, or regulations Moreover, external adjustment, under favorable
conditions, is attained without requiring major domestic or internal price, income, or
employment changes Its two major disadvantages are: (1) uncertainty and instability in
the form of frequent and large fluctuations discourages international trade, transactions,
and investment; and (2) there is the possibility of exchange rate fluctuations leading to
cumulative disequilibrium rather than stable equilibrium
Suppose American preferences for French goods—say, wines and perfumes—
increase for some reason The demand for francs will rise because Americans will need
more francs to buy the additional French goods they desire If, as in Figure 17.7, the U.S
demand for francs shifts from D1 to D 2 , the quantity of francs demanded at the old
equilibrium exchange rate of ER1 will exceed the quantity supplied Those who cannot
buy more francs at ER1 will offer to pay a higher price The exchange rate will rise
toward the new equilibrium level of ER1 as the equilibrium point shifts from E1 to E2.
As the dollar depreciates in value, the imbalance in payments is eliminated
_
FIGURE 17.7 Effect of an Increase in Demand
for Francs
An increase in the demand for francs will shift the
demand curve from D1 to D2 , pushing the
equilibrium from E1 to E 2 At the initial
equilibrium exchange rate ER1, a shortage will
develop Competition among buyers will push the
exchange rate up to the new equilibrium level ER2
Trang 2Now suppose Americans’ real incomes rise Assuming that the consumption of
goods and services goes up with real income—we called these “normal” goods and
services earlier in the book – Americans will be likely to demand more foreign imports,
both directly and in the form of domestic goods that incorporate foreign parts or
materials Either way, an increase in real incomes leads to an increase in the demand for
foreign currencies Again the demand for francs will rise, as in Figure 17.7 The
exchange rate will rise with it to bring the quantity supplied into line with the quantity
demanded
A change in the rate of inflation can have a similar effect on the exchange rate If
the inflation rates are about the same in two nations that trade with each other, the
exchange rate between their currencies will remain stable, ceteris paribus, according to
the purchasing power parity theory Because the relative prices of goods in the two
nations stay the same, people will have no incentive to switch from domestic to imported
goods, or vice versa If one nation’s inflation rate exceeds another’s, however, the
relative prices of foreign and domestic goods change If prices increase faster in the
United States, for example, Americans will want to buy more foreign goods and fewer
domestic goods Foreigners, on the other hand, will have an incentive to buy more goods from their own countries, where prices are not rising as fast as in the United States In
sum, a higher U.S inflation rate spells a rise in the demand for foreign currencies, a
fallen in their supply, and a depreciation of the dollar Similar flows occur when there
are interest rate differentials between nations
Figure 17.8 illustrates the process for prices in general As U.S demand for
foreign goods rises, the demand curve for francs shifts outward from D1 to D 2 , shifting
the equilibrium from E1 to E 2 As foreign demand for U.S products falls, the supply
curve for francs shifts to the left, from S1 to S2 At the initial equilibrium exchange rate
of ER1, a shortage of francs will develop The exchange rate will rise to ER2, eliminating
the shortage and reestablishing balance in the money market At the higher rate,
Americans must pay a higher dollar price for foreign goods The rise in the exchange
rate has evened out the difference in the two nations’ inflation rates
_
FIGURE 17.8 Effect of an Increase in Inflation on
the Supply and Demand for Francs
If the rate of inflation is higher in the United States
than in France, the demand for francs will rise from
D1 to D 2 , while the supply of francs will contract
from S1 to S2 The dollar price of francs will rise
from ER1, to ER2, as the equilibrium shifts from
E1, to E2
Trang 3In the short-run, supply and demand are most influenced by anticipations as to the direction in which an exchange rate is likely to move For example, if the franc is
expected to increase in value, people who have payments to make in that currency will
tend to buy the currency and make payments sooner Economic and political news—such
as an unanticipated change in monetary policy—has an almost immediate impact
Control of the Exchange Rate:
The Fixed or Pegged Rate System
So far our analysis of the international money market has assumed a floating, or flexible,
system of exchange in which exchange rates are determined by private demand and
supply forces in the market A floating, flexible, or freely fluctuating exchange rate
system is one in which the prices of currencies are determined by competitive market
forces Until 1971, however, international exchange rates were controlled by
governments Rates were not permitted to move in response to changes in supply and
demand Because rates were fixed for long periods of time by government decree, this
system is generally referred to as a fixed exchange rate system A fixed or pegged
exchange rate system is one in which the prices of currencies are established and
maintained by government intervention Although the fixed-rate system is no longer in
use among major nations, it merits some discussion because of its historical importance
and because of periodic high-level discussions—especially in the late 1980s—about
returning to it
To understand that a properly working fixed exchange rate system can be better
than a floating-rate system, consider the problems that would arise if each state in the
United States had its own currency The exchange rate would vary among all the states
The resulting risks and inconveniences would severely hamper interstate trade For
instance, a worker in New York City who commutes from New Canaan, Connecticut,
would have to face fluctuating exchange rates on a daily basis when riding subways,
buying gas, eating lunch, whatever
The fixed exchange rate has one advantage over the floating rate: it is stable
Because even a small change in the exchange rate can cause significant losses to people
who have already concluded business deals, a flexible exchange rate can increase the
risks involved in international trade For example, suppose you agree to purchase cheese
at an exchange rate of $0.10 = F1 You promise to pay the exporter $00, and the French cheesemaker expects to receive F5,000 By the time you send the check, however, the
rate has moved to $0.11 = F1 The exporter will now receive only F4,545 ($500 ÷ 0.11) She loses F455
If the exchange rate moves in the opposite direction, of course, the exporter will
gain In addition, the French cheesemaker can hedge against short-term losses by
agreeing, at the time she closes the deal, to sell the proceeds at a given exchange rate,
perhaps a fraction of a cent less than the current rate of $.10 = F1 In long-term deals,
however, traders inevitably risk losing money because of changes in exchange rates
Trang 4They incur a risk cost that is translated into higher prices Under a fixed-rate system,
exchange rates move only periodically The risk cost is reduced, and the prices of foreign goods can be lower
Like any other form of price control, however, control of foreign exchange rates
creates its own problems If the exchange rate is fixed—at ER1 in Figure 17.8, for
example—and the supply and demand curves remain stable, there is no problem There
is no need for government to fix the rate either, however, It will remain ER1 as long as
the supply and demand curves for currency stay put
Problems can develop when market conditions change but the exchange rate is
fixed If the demand for francs increases from D1 to D2 in Figure 17.8, a shortage of
francs will develop on the international money market Those who want francs at the
fixed price will be unable to get all they want The government may have to ration the
available francs and police the market against black marketeering If black markets are
not controlled, the price of currency will rise—illegally perhaps, but it will rise
nonetheless In the end, the exchange rate will not really be controlled
Perhaps the chief disadvantage of a fixed rate system is that the level of internal
prices and costs in each nation is affected by external economic and monetary
developments over which a nation has little or no control Nations must play according
to the rules of the game and submit their internal economy to the dictates of external
equilibrium
Concluding Comments
The schedule of tariffs applied to goods coming into the United States is now larger than
the Los Angeles telephone directory Surely all those tariffs were not imposed in pursuit
of the national interest, as in the maintenance of a strong defense industry Most
probably reflect the political influence of special-interest groups Yet on balance, the
overall tariffs are low, but they mask very high tariffs and even quotas on certain
commodities—such as certain agricultural products, tobacco, motorcycles, and cooking
utensils
The case against such special-interest tariffs was wittily stated by the
nineteenth-century French economist Frederic Bastiat Pretending to represent the candle
manufacturers of his day, he wrote to the French Chamber of Deputies in 1845:
Gentlemen:
.We are subjected to the intolerable competition of a foreign rival, who enjoys,
it would seem such superior facilities for the production of light that he is enabled
to inundate our national market, at so exceedingly reduced price, that, the
moment he makes his appearance, he draws off all customs for us; and thus an
important branch of French industry is suddenly reduced to a state of complete stagnation This rival is no other than the sun
Our petition is, that it would please your honorable body to pass a law whereby shall be directed the shutting up of all windows, doors, skylights, shutters,
Trang 5curtains, in a word, all opening, holes, chinks, and fissures through which light of
the sun penetrates into our dwellings.10
Bastiat suggests that passage of his proposed law would be consistent with the chamber’s attempts to check the importation of “coal, iron, cheese, and goods of foreign
manufacture, merely because and even in proportion as their price approaches zero.”
Clearly, tariffs force consumers to pay more for domestic goods In that extent
they reduce aggregate real income Unfortunately because they benefit special-interest
groups—tariffs, like other taxes, are probably inevitable
Review Questions
1 Using supply and demand curves, show how a U.S tariff on a foreign-made good
will affect the price and quantity sold in the country of origin
2 How will an import quota on sugar affect the price of sugar produced and sold
domestically? Sugar produced domestically and sold abroad?
3 If a tariff is imposed on imported autos and the domestic demand for autos rises,
what will happen to auto imports? If a quota is imposed on imported autos and the demand for autos increases, what will happen to auto imports?
4 Given the following production capabilities for cheese and bread, which nation will
export cheese to the other? What might be a mutually beneficial exchange rate for
cheese and bread?
5 “Tariffs on imported textiles increase the employment opportunities and incomes of
domestic textiles workers They therefore increase aggregate employment and
income.” Evaluate this statement
6 Since the balance of payments must always balance, how can a disequilibrium
situation occur?
7 How much would a business spend to get a tariff? What economic considerations
will have an impact on the amount?
10
Frederic Bastiat, “A Petition,” Economic Sophisms (Irvington-on-Hudson, N.Y., Foundation for
Economic Education, 1964; originally published 1945), purchasing power 56-60