International Trade

Exchange rates

Exchange rates of a current is its price in term of another currency. There are a few exchange rate systems:

1. Floating exchange rate system
   • The exchange rate in a floating exchange rate system is determined by market forces.
   • If the exchange rate decreases:
     • the prices of export also decrease, thus increasing export revenue since demand are price elastic.
     • the import prices will increase, thus decreasing import spending
     • the balance of payments disequilibrium is automatically corrected.
2. Fixed exchange rate system
   • In a fixed exchange rate system, the currency is pegged at that level.
   • If a country has an excess supply of currency, then the central bank will use the reserves of currency to buy up on the foreign exchange market
   • advantages of fixed exchange rates is that it eliminate risk of foreign exchange losses, thus promoting international trade.

Balance of payments deficit and fixed exchange rate

1. raise interest rate to attract hot money (but that will decrease consumer spending and increase unemployment)
2. deflate economy (by increasing taxes and decreasing government spending) to reduce import spending (this will cause recession and unemployment)
3. protectionist policies (retaliate competitors, GATT bans)
4. devalue the currency (this will increase import prices which is inflationary)
   • devaluation (fixed exchange rate system - one time improvement)
   • depreciation (floating exchange rate or free fall)