shifting the currency demand curve shifting the currency supply curve

$ per bop IP = $ por boplp =

price of 5 Of bones 51 Of bop les

price of
Sz
bop IPs in 2. central bank buys excess bones in
←2. imports are reduced

#
terms of $ bop 10s increasing demand
, terms of $
,

therefore the supply of

" " ° " "" B 1) 0PM falls
2. 00 - - -
AB - - - - of
-
zoo - - -
ta - - - *A
7. fall in demand for

/
7. fall in demand for
1.50
q -4 Bop land 's exports reduces
/ Bop
- - - -
- -

land 's exports reduces

tr demand for bones demand
← for 130PM

Dz for bop 105 Di for bones Dz for bones D , for bop 1ps
o o
Q Of bones Q Of bones

Ib) Increases in interest rates and contraction any monetary /fiscal policy letforts to limit imports ) may lead to a recession in the domestic

economy ; extensive borrowing from abroad comes wid number of costs ; trade protection trade policies /efforts to limit imports ) comes

with numerous disadvantages , including the possibility of retaliation by trading partners which would result in , lower exports ;

exchange controls have the effect of causing serious resource misallocation

3. (a) It a currency has a higher value than can be maintained through intervention , the government may change the fixed rate to a new ,

lower value ; this is called devaluation of the currency If a currency has .

a lower value than can be maintained by intervention , the

government may set a new higher value ; this is called revaluation of the currency

Ib ) Devaluation : When a currency has a higher value than can be maintained through intervention

Revaluation : when a currency has a lower value than can be maintained by intervention

4. 191 like appreciation , devaluation results in cheaper exports to foreigners and more expensive imports for domestic residents , thus giving rise

to more exports and fewer imports However , . a devaluation occurs when a country makes a conscious decision to lower its exchange

rate , while a depreciation occurs when there's a fall in the value of a currency .

(b) like appreciation , revaluation leads to more expensive exports to foreigners and cheaper imports for domestic residents , and therefore

fewer exports and more imports However

.
,
a revaluation occurs when a country makes a conscious decision to raise its exchange

rate , while a depreciation occurs when there's a rise in the value of a currency .

5 .
Because when there's an upward pressure on the currency due to excess demand , the central bank can keep on selling the domestic currency

and buying foreign exchange , thus maintaining the exchange rate -

as the need for additional measures to maintain a fixed exchange

rate arises primarily when there's an excess supply of the domestic currency over a long time .

MANAGED EXCHANGE RATES I MANAGED FLOAT )

understanding managed exchange rates

01 In between the 2 extremes of fixed exchange rates + floating exchange rates is the system of managed exchange rates /the managed float

-
combining elements of both , though closer to floating exchange rates this is the current system
,
in use since 1973

-
exchange rates are for the most part free to float to their market levels 1 their equilibrium levels ) over long periods of time ; however,

central banks periodically intervene to stabilize them over the short term

01 The objective of central bank intervention is to prevent large 1- abrupt fluctuations in exchange rates that could arise if currencies were

left entirely to free market forces

-
target abrupt exchange rate changes disrupt the orderly flow of international trade + create uncertainties that undermine investment -1

economic activity

in a managed float , the currency is supposed to move towards its long-term equilibrium position determined by the market

→
central banks intervene so that this adjustment can occur in a smooth -1 Orderly way , w/o major -1 abrupt fluctuations that may

destabilize the economy

01 Intervention mainly takes the form of buying + selling of currencies by the central bank , influencing currency demand + supply
-
in addition central banks may change interest rates, which also
, impacts exchange rates

-
v infrequently / mainly in the event of a severe disequilibrium where there's a strong downward pressure on the value of a currency ) ,

9 outs may have to resort to contraction dry macroeconomic policies /trade protection measures / as in the case of fixed exchange rates )

pegging exchange rates

01 A number of developing countries pool I fix ) their Gurrenoils to the us D. + float together w/ it , while a few transition economies ppg their

currencies to the euro

01 The pegged currency is allowed to fluctuate only within a narrow range above + below a target exchange rate relative to USD1 euro so that ,

if the actual exchange rate hits the upper / lower limit of the range the central bank
, intervenes to keep it within the limits
 01 suppose Bop land decides to peg the boplp to the USD , as shown in Fi 9.14 -4

- the target exchange rate chosen is 2USD __ 1 Do pie ; the boplp is allowed to $ Per bone =
price of s
fluctuate up to a Max of 2.10ns D= 1 bop IP , 1- a min of 1.90 us D= 7 bople bop IPs in
terms 2.10 - - - - - - - - - - - - - - -

-
suppose that market forces cause the exchange rate to drop to 1.90USD = 1 of $
2.00 D
- - - - - - - - - - - -
}
1) 0PM due to a fall in the demand for bop IPs from D , to Dz
1.90 - - - - - - - -

→ at that point , the Bank of Bop / and 1the central bank ) will intervene
D,
by buying bones 1-1 selling us D) , so that the demand for bop IPS - -
curve
Dz

Will stop shifting leftward + the bone stops falling

0
→ if the boplp increases in value -1 hits the Max of 2.10USD = 1 bop IP boot Q Of bones

an increase in the demand for bones from Dito D } the central bank .

figure 14.4 Illustrating a pegged currency

will intervene by selling bones It buying us D) to prevent a further rise in the value of the bop le

01 A pegged currency combines fixed + managed exchange rates, bo the pegged currencies are fixed within the specified range of the USD / the

euro , + they float in relation to all other currencies , together w/ the USD / the Puro

01 The main reason for pegging currencies is that this stabilizes the exchange rate of the pegged currency in relation to the currency to which

it is pegged preventing abrupt /strong

, fluctuations

-
developing countries that peg their currencies to the USD experience exchange rate stability relative to the USD as well as relative to each

other , -1 this facilitates trade flows w/ the us as well as between countries w/ pegged currencies

01 Under the managed float , exchange rates are determined mainly through market forces, but w/ periodic intervention by central banks aiming

to smooth out abrupt fluctuations

-
intervention takes mainly the form of the buying -1 selling of official reserves

01 some developing + transition economies ppg their currencies to the USD /euro ; pegged currencies are fixed in relation to the USD1 euro , -1 float

in relation to all other countries

consequences of overvalued + undervalued currencies

01 An overvalued currency is one that has a value that 's too high relative to its equilibrium free market value

-
its exchange rate has been set at a higher level than the equilibrium market exchange rate

01 An undervalued currency is one whose value is too low relative to its equilibrium free market value

-
its exchange rate is low relative to the one the market would 've determined

01 Overvalued -1 undervalued currencies can't come about in a freely floating exchange rate system , where exchange rates are determined

purely by demand + supply

-
however, they cant do often occur in fixed 1- managed exchange rate systems

01 Figure 14.1191 illustrates both overvalued 1- undervalued currencies

-
the market determines a price of USD at 0.67 euro = 7USD

-
if the US central bank / Federal Reserve ) wanted to overvalue the USD , it could try to maintain a price in terms of the euro above the

equilibrium such . 05 at 0.80 euro = 7USD

-
in the case of an undervaluation the central bank would select
, a price of the USD in terms of the euro below the equilibrium price , such

as at 0.50 euro : 1USD

01 The overvaluation / undervaluation of the currency can be achieved by central bank + govt interventions that maintain the exchange rate at

the selected level / range of levels , as when a currency is pegged

01 There are a number of advantages that may arise from overvaluation / undervaluation of currencies , though these generally come w/ costs

01 Overvalued currencies

-
most developing countries have at one time / other had overvalued exchange rates

→ if an exchange rate is overvalued ,

imports become cheaper
→ the main reason for overvaluing their exchange rates is that many developing countries have wanted cheap imports of capital

goods , raw materials + other inputs for use in manufacturing industries , to speed up industrialization
-
however , overvalued exchange rates come w/ many disadvantages
→
exports become more expensive thus negatively affecting domestic exporters
,

↳ increased imports + reduced exports lead to a worsening current account balance , resulting in payments difficulties
→ by increasing imports , domestic producers have to compete w/ artificially low -

price imports
↳ negative consequences for domestic employment + resource allocation

→ has often resulted in the need for countries to devalue / depreciate their currencies to correct the overvaluation
 01 Undervalued currencies

-
when a currency is undervalued , exports become less expensive to foreign buyers , while imports become more expensive domestically

-
some developing countries have used undervaluation as a method to expand their export industries , expand their economies + therefore

also increase their employment levels

→ achieving these objectives by means of an undervalued currency is considered to involve the creation of an unfair competitive

advantage compared to other countries that don't undervalue their currencies , -1 Which suffer the consequences of increased

imports -1 lower exports

→ currency undervaluation is therefore considered to be a kind of ' cheating '

-
in the context of a managed float , undervalued currencies are sometimes referred to as a ' dirty float
'

-
correction of the undervalued our renal would involve revaluation / appreciation of the currency

TEST YOUR UNDERSTANDING 14.5

1. 191 Exchange rates are for the most part free to float to their market levels / their equilibrium levels ) over long periods of time , like the floating

exchange rate system : however central banks , periodically intervene to stabilize them over the short term like fixed exchange rate systems
,

(b) Exchange rates are determined mainly through market forces of supply and demand

2 . The objective of central bank intervention is to prevent large and abrupt fluctuations in exchange rates that could arise if currencies were

left entirely to free market forces as large and

, abrupt exchange rate changes disrupt the orderly flow of international trade and create

uncertainties that undermine investment and economic activity -

destabilizing the economy .

3. The pegged currency is allowed to fluctuate only within a narrow range above and below a target exchange rate relative to USD1 euro so ,

that if the actual exchange rate hits the upper / lower limit of the range the central bank
, intervenes to keep it within the limits

4. lol ) An overvalued currency is one that has a value that 's too high relative to its equilibrium free market value ; its exchange rate has been set

at a higher level than the equilibrium market exchange rate An undervalued currency
.
is one whose value is too low relative to its

equilibrium free market value ; its exchange rate is low relative to the one the market would 've determined .

Ib) The main reason for overvaluing their exchange rates is that many developing countries have wanted cheap imports of capital

goods , raw materials and other inputs for use in manufacturing industries , to speed up industrialization ; while some developing
countries have used undervaluation as a method to expand their export industries , expand their economies and therefore also increase

their employment levels .

In overvalued :
exports become more expensive thus negatively affecting domestic exporters ; increased imports and reduced exports
,

lead to a worsening current account balance , resulting in payments difficulties ; by increasing imports , domestic producers

have to compete with artificially low price imports which poses negative consequences for domestic
-
, employment and

resource allocation ; has often resulted in the need for countries to devalue / depreciate their currencies to correct the

overvaluation

undervalued : involve the creation of an unfair competitive advantage compared to other countries that don't undervalue their

currencies , and which suffer the consequences of increased imports and lower exports

5. Ion Because there is no intervention in the form of fixing / changing exchange rates in a freely floating exchange rate system , where

exchange rates are determined purely by demand and supply

(b) Because it's considered to be a kind of cheating , when countries undervalue their currencies -
creating an unfair competitive advantage

compared to other countries that don't undervalue their currencies , and which suffer the consequences of increased imports and

lower exports