AP_Krugman_Textbook

The immediate question about a fixed exchange rate is how it is possible for gov-

ernments to fix the exchange rate when the exchange rate is determined by supply

and demand.

How Can an Exchange Rate Be Held Fixed?

To understand how it is possible for a country to fix its exchange rate, let’s consider a

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 belowthe target exchange

rate. Panel (b) shows the case in which the equilibrium value of the geno is abovethe

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.

432 section 8 The Open Economy: International Trade and Finance

Quantity of genos

US$1.50

0

S

D

E

(a) Fixing an Exchange Rate

Above Its Equilibrium Value

Target

exchange

rate

Quantity of genos

US$1.50

0

Exchange

rate (U.S.

dollars

per geno)

Exchange

rate (U.S.

dollars

per geno)

S

D

E

(b) Fixing an Exchange Rate

Below Its Equilibrium Value

Target

exchange

rate

Surplus at exchange rate

of US$1.50 per geno

Shortage at exchange rate

of US$1.50 per geno

figure 43.1 Exchange Market Intervention

In both panels, the imaginary country of Genovia is trying to keep

the value of its currency, the geno, fixed at US$1.50. In panel (a),

there is a surplus of genos on the foreign exchange market. To keep

the geno from falling, the Genovian government can buy genos and

sell U.S. dollars. In panel (b), there is a shortage of genos. To keep

the geno from rising, the Genovian government can sell genos and

buy U.S. dollars.

Government purchases or sales of currency in
the foreign exchange market constitute
exchange market intervention.

Foreign exchange reservesare stocks of
foreign currency that governments maintain
to buy their own currency on the foreign
exchange market.