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Unformatted text preview: Fundamentals of Exchange Rate Systems Chapter 13 Fundamentals of Exchange Rate Systems Learning objectives By the end of this chapter you should be able to understand: That the mechanism of supply and demand for foreign currency works the same way as supply and demand for any other commodity the difference between flexible and fixed exchange rates, and how their price is determined that a fixed exchange rate does not happen naturally and requires continuous attention on the part of countries central banks how one exchange rate system can isolate the economy from outside shocks while the another may transmit foreign policy changes to the domestic economy the specific circumstances under which changes in the price of foreign currency may improve or worsen the balance of trade why foreign trade may adjust sluggishly to changes in the exchange rate The basic tenet of chapter 1 rests on the idea that the B0P is a double entry accounting device and must always balance i.e. BoP=0 at all time. But we also hear about imbalances in the balance of payments, and this chapter clarifies what such imbalances may be. For instance, we hear about chronic trade deficits and there seems to be a popular notion that such deficits cannot be sustained indefinitely. These imbalances refer directly to subcomponents of the BoP - imbalances related to trade, to capital flows, to central bank interventions. Our discussion now switches from describing the BoP as an accounting device, to studying the economic forces underlying and affecting the various subcomponents of the B0P: some BoP components may be causing imbalances, others can be triggering an adjustment. Formally, from now on we are switching from the ex-post approach in chapter 12 (where we simply reconciled transactions that had taken place in a balance sheet) to an ex-ante approach where we are looking for relations between the BoP components that allow us to predict how they behave together. 1 Our goal is to formulate models, or frameworks, that help us understand the effects of such imbalances. The BoP happens to be a marvelous instrument that highlights all imbalances at once; it helps us study each components effect on every aspect of the economy....
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This note was uploaded on 04/29/2008 for the course ECON 472 taught by Professor Eicher during the Winter '08 term at University of Washington.
- Winter '08
- Supply And Demand