Page 473 - Krugmans Economics for AP Text Book_Neat

What you will learn
in this Module:

Module 43 • The difference between fixed
exchange rates and floating
exchange rates
Exchange Rate Policy • Considerations that lead

countries to choose different
exchange rate regimes.

Exchange Rate Policy

The nominal exchange rate, like other prices, is determined by supply and demand. Un-
like the price of wheat or oil, however, the exchange rate is the price of a country’s
money (in terms of another country’s money). Money isn’t a good or service produced
by the private sector; it’s an asset whose quantity is determined by government policy.
As a result, governments have much more power to influence nominal exchange rates
than they have to influence ordinary prices.
The nominal exchange rate is a very important price for many countries: the ex-
change rate determines the price of imports; it determines the price of exports; in
economies where exports and imports are large relative to GDP, movements in the ex-
change rate can have major effects on aggregate output and the aggregate price level.
What do governments do with their power to influence this important price?
The answer is, it depends. At different times and in different places, governments
have adopted a variety of exchange rate regimes. Let’s talk about these regimes, how they
are enforced, and how governments choose a regime. (From now on, we’ll adopt the con-
vention that we mean the nominal exchange rate when we refer to the exchange rate.)

Exchange Rate Regimes
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 govern-
ment lets the exchange rate go wherever the market takes it. This is the policy followed An exchange rate regime is a rule
by Britain, Canada, and the United States. governing policy toward the exchange rate.
Fixed exchange rates and floating exchange rates aren’t the only possibilities. At var- A country has a fixed exchange rate when
ious times, countries have adopted compromise policies that lie somewhere between the government keeps the exchange rate
fixed and floating exchange rates. These include exchange rates that are fixed at any against some other currency at or near a
given time but are adjusted frequently, exchange rates that aren’t fixed but are “man- particular target.
aged” by the government to avoid wide swings, and exchange rates that float within a A country has a floating exchange rate
“target zone” but are prevented from leaving that zone. In this book, however, we’ll when the government lets the exchange rate
focus on the two main exchange rate regimes. go wherever the market takes it.

module 43 Exchange Rate Policy 431