1Topic 7-3 Exchange Rate Policy Review Nominal Exchange Rate- price that is determined by supply and demand in the XR market However, a nation can deliberately manipulate the exchange rate of its own currency to achieve economic goals. Why? Because the exchange rate has a great deal of influence Exchange Rate Regimes- rules governing policy toward exchange rates Two Kinds of Exchange Rate Regimes: 1. Fixed Exchange Rate: when the government keeps the XR against another currency at or near a particular target Ex. Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$12. Floating Exchange Rate: when the government lets the exchange rate go wherever the market takes it Ex. This is the policy followed by Britain, Canada, and the USBut if the exchange rate is determined by market forces of supply and demand, how can it be held fixed?Suppose the small nation of Sarasha decides to fix their currency, the rash, at a rate of $2 US for every 1 r.If the rash is exchanged in a free market, the equilibrium exchange rate may be higher, or lower, than the target rate of $2.2____________________________________________________________________________________The Equilibrium Exchange RateThe price of a currency, or exchange rate, is determined in the market with forces of supply and demand.If I want pesos, I demand them. In order to acquire pesos, I must supply dollars to the exchange market. When demanding more of a foreign currency, you must supply more of your ownGraphing the market for US dollars. X axis- Quantity of UIS dollars Y axis- price of US dollars measured in: (in this example, in pesos) so: “Exchange rate (pesos/dollar)”What goes below goes below! Dollars is in the denominator of Y as well as on the XEquilibrium Exchange rate is 12.4 Mexican Pesos per US dollar. Where is this point located on your graph?At the equilibrium exchange rate of 12.5 pesos/dollar, the quantity of dollars demanded is equal to theWhy does the Demand for dollars slope downward?- As the price of a dollar falls (its value depreciates) it takes fewer pesos to buy one dollar.Is it actually a good idea to fix the exchange rate?As we know, at the target of $2, there is now a surplus of r ashas in the foreign exchange market which would normally pushthe exchange rate down to $1 per rash.The government of Sarasha can:1. Buy up the surplus of rashes in the foreign exchange market; this is called exchange market intervention a. The government must have dollars for this purchase which is why governments keep foreign exchange reserves or stocks of foreign currencies 2. The government can try to shift either the D or S curve so that the P rises to the target of S2 a. Maybe the central bank increases interest rates  attracting foreign capital investment  increases D for the rash  this will reduce capital outflow 3. The government can limit the right of individuals to buy foreign currencya. Ex: require citizens to acquire a license to purchase a dollar As we know, at the target of $2, there is now a shortage of rashas in the foreign exchange market whichwould normally push the exchange rate up to $3 per rash.The government of El Tigardo can:1. Sell rashes in the foreign exchange market 2. Central bank can decrease interest rates 3. Government can limit the ability of foreigners to buy the rash3Advantage: Stability A fixed exchange rate provides stability in foreign transactions in much the same way we experiencetransactions across state lines. If you take your dollars from Indiana to Kentucky, you know that the valueof your dollars is unchanged. But if you take your dollars from Indiana to Europe, the value of thosedollars 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 theexchange rate. For example, if the bank adhered to the exchange rate regime, the bank could notdramatically increase the money supply. This would cause inflation and reduce the value of the currency.More stability.Disadvantage: Costs To stabilize an exchange rate through intervention, a country must keep large quantities of foreigncurrency 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 andexporting goods and services. They can also create substantial costs in terms of red tape and corruption.PS 7-31. Which of the following methods can be used to fix a country’s exchange rate at a predetermined level?I. Using foreign exchange reserves to buy its own currency II. Using monetary policy to change interest rates III. Implementing foreign exchange controls a. I onlyb. II onlyc. III onlyd. I and II onlye. I, II, and III2. Changes in exchange rates affect which of the following?a. The price of importsb. The price of exports c. Aggregate demandd. Aggregate output e. All of the above3. The U.S. has which of the following exchange rate regimes?a. fixed4b. floating c. fixed, but adjusted frequently d. fixed, but managede. floating within a target zone4. Which of the following interventions would be required to keep a country’s exchange rate fixed ifthe equilibrium exchange rate in the foreign exchange market were below the fixed exchange rate (measured as units of foreign currency per unit of domestic currency)? The government/central banka. Buys the domestic currencyb. Sells the domestic currencyc. Buys the foreign currencyd. Lowers domestic interest ratese. Removes foreign exchange controls5. Which of the following is a benefit of a fixed exchange rate regime?a. Certainty about the value of domestic currencyb. Commitment to inflationary policiesc. No need for foreign exchange reservesd. Allows unrestricted use of monetary policye. All of the above5Problem 7CSuppose the US and India were the only two countries in the world. a. Draw a correctly labeled graph of the foreign exchange market for US dollars showing the equilibrium in the market. b. On your graph, indicate a fixed exchange rate set above the equilibrium exchange rate. Does the fixed exchange rate lead to