We mentioned earlier that an important part of international capital flows is the
result of purchases and sales of foreign assets by governments and central banks.
Now we can see why governments sell foreign assets: they are supporting their cur-
rency through exchange market intervention. As we’ll see in a moment, governments
that keep the value of their currency downthrough exchange market intervention
mustbuyforeign assets. First, however, let’s talk about the other ways governments
fix exchange rates.
A second way for the Genovian government to support the geno is to try to shift the
supply and demand curves for the geno in the foreign exchange market. Governments
usually do this by changing monetary policy. For example, to support the geno, the
Genovian central bank can raise the Genovian interest rate. This will increase capital
flows into Genovia, increasing the demand for genos, at the same time that it reduces
capital flows out of Genovia, reducing the supply of genos. So, other things equal, an
increase in a country’s interest rate will increase the value of its currency.
Third, the Genovian government can support the geno by reducing the supply of
genos to the foreign exchange market. It can do this by requiring domestic residents
who want to buy foreign currency to get a license and giving these licenses only to peo-
ple engaging in approved transactions (such as the purchase of imported goods the
Genovian government thinks are essential). Licensing systems that limit the right of in-
dividuals to buy foreign currency are called foreign exchange controls.Other things
equal, foreign exchange controls increase the value of a country’s currency.
So far we’ve been discussing a situation in which the government is trying to prevent
a depreciation of the geno. Suppose, instead, that the situation is as shown in panel (b)
of Figure 43.1, where the equilibrium value of the geno is abovethe target exchange rate
and there is a shortage of genos. To maintain the target exchange rate, the Genovian
government can apply the same three basic options in the reverse direction. It can in-
tervene in the foreign exchange market, in this case sellinggenos and acquiring U.S. dol-
lars, which it can add to its foreign exchange reserves. It can reduceinterest rates to
increase the supply of genos and reduce the demand. Or it can impose foreign ex-
change controls that limit the ability of foreigners to buy genos. All of these actions,
other things equal, will reduce the value of the geno.
As we said, all three techniques have been used to manage fixed exchange rates. But
we haven’t said whether fixing the exchange rate is a good idea. In fact, the choice of
exchange rate regime poses a dilemma for policy makers because fixed and floating ex-
change rates each have both advantages and disadvantages.
The Exchange Rate Regime Dilemma
Few questions in macroeconomics produce as many arguments as that of whether a
country should adopt a fixed or a floating exchange rate. The reason there are so many
arguments is that both sides have a case.
To understand the case for a fixed exchange rate, consider for a
moment how easy it is to conduct business across state lines in the
United States. There are a number of things that make interstate
commerce trouble - free, but one of them is the absence of any uncer-
tainty about the value of money: a dollar is a dollar, in both New
York City and Los Angeles.
By contrast, a dollar isn’t a dollar in transactions between
New York City and Toronto. The exchange rate between the Cana-
dian dollar and the U.S. dollar fluctuates, sometimes widely. If
a U.S. firm promises to pay a Canadian firm a given number of
U.S. dollars a year from now, the value of that promise in Cana-
dian currency can vary by 10% or more. This uncertainty has
the effect of deterring trade between the two countries. So one
benefit of a fixed exchange rate is certainty about the future value
of a currency.
module 43 Exchange Rate Policy 433
Section 8 The Open Economy: International Trade and Finance
Foreign exchange controlsare
licensing systems that limit the right of
individuals to buy foreign currency.Once you cross the border into Canada, a
dollar is no longer worth a dollar.Robert Nickelsberg/Getty Images