Page 474 - Krugmans Economics for AP Text Book_Neat

The immediate question about a fixed exchange rate is how it is possible for gov-
Government purchases or sales of currency in
ernments to fix the exchange rate when the exchange rate is determined by supply
the foreign exchange market constitute
and demand.
exchange market intervention.
Foreign exchange reserves are stocks of
foreign currency that governments maintain How Can an Exchange Rate Be Held Fixed?
to buy their own currency on the foreign
To understand how it is possible for a country to fix its exchange rate, let’s consider a
exchange market.
hypothetical country, Genovia, which for some reason has decided to fix the value of its
currency, the geno, at US$1.50.
The obvious problem is that $1.50 may not be the equilibrium exchange rate in the
foreign exchange market: the equilibrium rate may be either higher or lower than the
target exchange rate. Figure 43.1 shows the foreign exchange market for genos, with
the quantities of genos supplied and demanded on the horizontal axis and the ex-
change rate of the geno, measured in U.S. dollars per geno, on the vertical axis. Panel (a)
shows the case in which the equilibrium value of the geno is below the target exchange
rate. Panel (b) shows the case in which the equilibrium value of the geno is above the
target exchange rate.
Consider first the case in which the equilibrium value of the geno is below the target
exchange rate. As panel (a) shows, at the target exchange rate there is a surplus of genos
in the foreign exchange market, which would normally push the value of the geno
down. How can the Genovian government support the value of the geno to keep the
rate where it wants? There are three possible answers, all of which have been used by
governments at some point.
One way the Genovian government can support the geno is to “soak up” the surplus
of genos by buying its own currency in the foreign exchange market. Government pur-
chases or sales of currency in the foreign exchange market are called exchange market
intervention. To buy genos in the foreign exchange market, of course, the Genovian
government must have U.S. dollars to exchange for genos. In fact, most countries
maintain foreign exchange reserves, stocks of foreign currency (usually U.S. dollars
or euros) that they can use to buy their own currency to support its price.

figure 43.1 Exchange Market Intervention

(a) Fixing an Exchange Rate (b) Fixing an Exchange Rate
Above Its Equilibrium Value Below Its Equilibrium Value
Exchange Exchange
rate (U.S. S rate (U.S. S
dollars Surplus at exchange rate dollars
per geno) of US$1.50 per geno per geno)

E
US$1.50 US$1.50
E
Target Target
exchange exchange
rate rate
Shortage at exchange rate
of US$1.50 per geno
D D
0 Quantity of genos 0 Quantity of genos

In both panels, the imaginary country of Genovia is trying to keep sell U.S. dollars. In panel (b), there is a shortage of genos. To keep
the value of its currency, the geno, fixed at US$1.50. In panel (a), the geno from rising, the Genovian government can sell genos and
there is a surplus of genos on the foreign exchange market. To keep buy U.S. dollars.
the geno from falling, the Genovian government can buy genos and

432 section 8 The Open Economy: Inter national Trade and Finance