Foreign Exchange

When an individual in one country wants to buy products from another, they must first buy some of the currency of the other country. The exchange rate between country A and country B (in a two-country model) is the same as a price in any competitive market. The demand curve for A’s currency is determined by the people who want to buy products produced by A, and the supply curve is determined by the people from A who want to buy products produced in B. As the exchange rate fluctuates, goods produced in country A will seem more or less expensive to residents of country B and vice versa, altering the quantity demanded and supplied. This is called a flexible exchange rate.

Some countries adhere to a fixed exchange rate policy, under which the governments of the nations involved agree to buy or sell enough of the currencies involved to keep the exchange rate at an agreed-upon value. The governments involved must add or subtract to demand and supply by amounts just sufficient to push the intersection to the price point desired. This involves adding to or subtracting from a currency reserves account, which will eventually run out of money. So fixed exchange rates cannot be maintained under all conditions.

The movement from fixed to flexible exhange rates was actually intended to stabilize prices. Under fixed exchange rate policies, large devaluations and revaluations occurred by when the official exchange rate was altered by government fiat. However, stability has not emerged. This is because the demand for a country’s currency does not depend exclusively on that nation’s exports.