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Economics: Floating and Fixed Systems

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  • Type: Video Tutorial
  • Length: 13:19
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 143 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: International Focus (25 lessons, $43.56)
Economics: Exchange Rates (6 lessons, $12.87)

In this video lesson on economics, you'll learn about floating and fixed systems for exchange rates. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Thinkwell
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Once you've developed a supply and demand tool, you can use the curves to predict the price in a market. Now that we have a demand for US dollars and a supply for US dollars, we can put the two curves together in a diagram and find out the equilibrium exchange rate and how it would be affected by changes in the economic environment.
Let's start by putting the two curves together. Remember the demand for dollars represents the behavior of Mexicans, who want dollars in order to buy goods, services and investments in the US. When the dollar appreciates, Mexicans find shopping in the US expensive and demand a smaller quantity of dollars. When the dollar depreciates, shopping in the US is a bargain and the quantity of dollars demanded increases. The supply curve represents the behavior of US nationals. When the dollar appreciates, US nationals find shopping in Mexico a bargain and therefore demand more goods, services and investments. Whenever the dollar depreciates, US nationals keep their money at home. Now, once you've got the demand and supply together, you can find the exchange rate at which the quantity of dollars demanded equals the quantity of dollars supplied. Then you've got price and quantity that give you equilibrium, like in any other supply and demand diagram.
Suppose now that we have an exchange rate that's not the equilibrium. Suppose we take this exchange rate here, e'. Maybe here our equilibrium is 10 pesos to the dollar. What happens at 8 pesos to the dollar? Well, Mexicans are very excited about shopping in the US, because it looks like a big bargain, so the quantity of dollars demanded is very large at that exchange rate. The quantity of dollars supplied, on the other hand, is quite small, because US nationals aren't getting such a good deal. With fewer dollars supplied than demanded, we have excess demand for dollars, which pushes up the price of dollars, which we call appreciation. As the dollar appreciates or the peso depreciates, Mexicans do less shopping in the US, US nationals want to do more shopping in Mexico and the market converges on this equilibrium. On the other hand, if we had an exchange rate like 12 pesos to the dollar, then US nationals are very excited about supplying dollars, because Mexico is a bargain for shopping and investing. On the other hand, Mexican nationals are uninterested, because they're not getting such a good deal, so they don't demand nearly as many dollars. We've now got excess supply in this market, excess supply of dollars, which causes the price of dollars to fall, which we call a depreciation of the dollar or an appreciation of the peso. As the peso appreciates, Mexicans want to do more shopping in the US, so the quantity of dollars demanded moves along this line as the quantity of dollars supplied moves back along the blue line, as US nationals decide they're less interested as the dollar depreciates, until finally equilibrium is restored. Once again, this is like the situation with any supply and demand diagram. The stable place is where the curves cross.
Now, the next step is what happens when one of the curves shifts? This is what we call comparative statics exercises. What happens when a change in the economic environment leaves Mexicans to demand a larger quantity of dollars at any given exchange rate? What's going to cause that to happen? First of all, review the catalog of factors that increase the demand for dollars: higher interest rates in the US, lower prices in the US, higher labor productivity in the US, and Mexican government lowering trade barriers against imports from the United States. Any of these things that occur make the US a more attractive place for Mexicans to do their shopping and investing, and therefore Mexicans demand a larger quantity of dollars at every exchange rate. The demand curve shifts outward.
When the demand curve shifts outward, then, at the original exchange rate, e*, we now have a larger quantity of dollars demanded than is supplied on the blue curve, excess demand for dollars. This leads to an adjustment, the price of the dollar rises, that is, the dollar appreciates, until equilibrium is reestablished with an exchange rate featuring more pesos to the dollar. So if Mexicans want more dollars, they're dumping more pesos into the foreign exchange market. Pesos are glutting the market, the price of pesos is falling, which means that the dollar is becoming more valuable in terms of pesos. Or think of it another way: excess demand for dollars drives up the price of dollars, leading to dollar appreciation until equilibrium is reestablished with an appreciated dollar or a depreciated peso.
The same thing is true if the supply curve shifts. Suppose the supply curve were to shift outward. Something changes in the economy, leading US nationals to want to offer more dollars for sale in exchange for pesos at any given exchange rate. If that occurs, then, at the original exchange rate, we've got excess supply of dollars. The quantity of dollars supplied relative to the quantity demanded is now too big. We have excess supply. And as in any case of excess supply, the price is going to fall to get rid of the glut. What happens then is the dollar depreciates. The exchange rate moves in this direction, fewer pesos to the dollar, until a new equilibrium is established at e*[1] with the dollar depreciated. So if US nationals are dumping their dollars on the market to buy more Mexican goods, then they're going lead to depreciation of the dollar. This will happen if interest rates are higher in Mexico, inflation is lower in Mexico or if the US lowers trade barriers against imports from Mexico, or of taxes in the US lead people to seek to import goods from Mexico instead.
Now, the typical situation is going to be that both curves will shift simultaneously. Why is that? Because most of the changes in the environment are going to change the position of Mexicans, as well as US nationals, in this market. For instance, suppose interest rates rise in the US. If interest rates in the US rise, that means that everyone, whether you're a Mexican or a US national, is going to get a better return on dollar-denominated stocks and bonds in the US market. So what's going to happen in that case? Well, first of all, Mexicans are going to want to get a piece of this action by buying US securities, and they're going to have to first buy dollars to get them. So the demand curve for dollars will shift outwards, meaning that, at any given exchange rate, Mexicans want to buy more dollars than before. Well, what's going to happen on the other side of the market? US nationals say, "Whoa, now that you can get a higher return on US investments, we want to keep our money at home." So the supply of dollars shifts inward, meaning that US nationals now want fewer dollars at any given exchange rate, because they want to buy their own securities rather than Mexican securities. What happens in this case is the supply curve shifts inward, the demand curve shifts outward and, at the original exchange rate, we've got this huge excess demand for dollars, which is going to be the case, because the US has become a more attractive place to invest. Everybody wants dollars, so the sellers are holding onto them at the same time as buyers are trying to get more. The result then will be this big change in the price, that is, a very, very large appreciation of the dollar. The price of the dollar in pesos goes up until equilibrium is reestablished at an exchange rate of e*[1].
So there you have it. We can't be sure which direction the quantity is going to move. It could be decreasing or increasing, depending on the relative magnitude of these shifts. But what is unambiguous is that an increase in the US interest rate is going to lead to an appreciation of the dollar.
Now, you can imagine another situation, in which taxes in the US increased, so that the curves shift in the opposite direction. Americans want to buy more Mexican products, Mexicans want to keep their money at home, and the dollar depreciates. Typically, any comparative statics exercise you do, any story you tell, is going to involve the shifting of both the red curve and the blue curve simultaneously. The only difference would be if there is a change that affects only one side of the market. For instance, suppose the United States lowers tariffs and quotas against imports from Mexico. In that case, it's going to be only the blue curve that shifts, because only US nationals are affected. The equilibrium exchange rate will adjust, but the original change, the reduction in trade barriers, affects only the people whose behavior is described on the blue curve, not the red curve. But, as a rule, inflation changes, interest rate changes, changes in labor productivity, all of those are going to create opportunities for people on both sides of the border, and therefore both the red curve and the blue curve will shift.
Now, everything that I've done here assumes that we're dealing with a free market for foreign exchange; that is, a market where the only people who are involved are private buyers and sellers, people who are shopping and investing. But what if the government gets involved in this market and doesn't like the direction that the free market is taking the exchange rate? What if the government decides to oppose the direction that the market is going? The government, or more specifically, the central bank of any country, has a big stock of foreign exchange reserves that it can use in order to influence the exchange rate. Kind of like you, if you had a big pot of money and wanted to influence the price of apples, could go out and buy up apples anytime you wanted to push up the price, or sell apples anytime you wanted to depress the price. You can always influence the price of one good or service by buying or selling a lot of it. Well, this is what happens in the foreign exchange markets. The central banks of particular countries have big stocks of foreign currency that they can buy and sell, in order to influence the price. What I've just drawn right here, when the government stays out of the game, is what's called a floating exchange rate, an exchange rate that moves with shifts in supply and demand, changes in the free market. On the other hand, if the government gets involved and has a target for the exchange rate, we have what is often called a fixed exchange rate. A fixed exchange rate doesn't necessarily mean that someone can just declare that the exchange rate is going to be 10 pesos to the dollar and it's going to stay there. But it does mean that the government can take action to try to keep the exchange rate at a target that it determines.
Let's suppose that Mexico decides that it wants a peso-dollar exchange rate equal to 10 pesos to the dollar. I'm going to use the subscript here "O" to represent official. That's the official fixed exchange rate. Now, let's suppose that interest rates rise in the United States, and when they do, the demand for dollars is going to increase as Mexicans try to invest in the United States. At the same time that the supply of dollars is shrinking due to US nationals wanting to keep their money at home - that is, if the market is left to its own devices, we're going to have an excess demand for dollars at that exchange rate and we're going to have a new exchange rate that represents an appreciation of the dollar or a depreciation of the peso. Now remember when the peso depreciates, it becomes more expensive for Mexicans to import goods from abroad. So if the government of Mexico wants to spare its investors and consumers that cost, it can try to push the exchange rate back to the official level. What's it going to do? Well, look what's happening. Mexicans want to buy more dollars at the same time that US nationals want to sell fewer. So what happens is the Bank of Mexico enters the market with an official foreign exchange transaction. What it does is supply more dollars to the market by selling dollars for pesos and giving the market what it wants. Since the market wants more dollars, the Bank of Mexico simply sells the dollars and takes all of those orphaned, unwanted pesos into its own vaults. When that happens, the increase in supply, due to this official action, creates excess supply at the exchange rate of 12 pesos to the dollar and pushes the market price back down to the official target. So by supplying dollars to a market that's hungry for dollars, the Bank of Mexico pushes the price back to the level where the government of Mexico wants to keep the exchange rate. This is what's called a fixed exchange rate and it's maintained by the bank of that country selling dollars when the market wants them and buying up dollars when the market doesn't. By buying and selling dollars, the Bank of Mexico keeps the exchange rate at the announced target.
Now, what's the limit on this activity? Well, if the Bank of Mexico wants to sell dollars anytime the market wants it, they'd better have dollars to sell, which means their foreign exchange reserves have to be sufficient to oppose the direction the market is trying to take. If the market is going in a direction of depreciation of the peso, the Mexican bank has got to have enough dollars to sell to keep the price from changing; otherwise, they're stuck and they've got to accept the market change, or else declare their currency in convertible; that is, simply shut the borders and not allow any further trade.
So, what we're going to do next is look at a particular instance from recent history, in which Mexico went from a fixed exchange rate to a floating exchange rate. Why did they have the fixed exchange rate to begin with? What problems did it create? What was the end of the story when they found it unsustainable?
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International Focus
Exchange Rates
Floating and Fixed Systems Page [3 of 3]

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