Question

Diagram a market in which the equilibrium dollar price of 1 unit of fictitious currency zee (Z) is \(5\) (the exchange rate is \(5=Z 1\) ). Then show on your diagram a decline in the demand for zee. LO39.4 a. Referring to your diagram, discuss the adjustment options the United States would have in maintaining the exchange rate at \(\mathrm{S} 5=\mathrm{Z} 1\) under a fixed-exchange-rate system. b. How would the U.S. balance-of-payments surplus that is caused by the decline in demand be resolved under a system of flexible exchange rates?

Short answer

In a fixed system, the U.S. sells dollars to maintain the exchange rate. In a flexible system, the rate adjusts automatically by appreciating the dollar.

Step-by-step solution

Plot the Initial Equilibrium

To diagram the market for zee, start by plotting the initial supply and demand curves for zee. On the y-axis, mark the price in dollars, and on the x-axis, mark the quantity of zee. The initial equilibrium is at Point E, where the price is 5 dollars per zee, indicating the exchange rate is 5 to 1. Let Demand be D1 and Supply be S. They intersect at E.

Illustrate the Decline in Demand

To depict a decline in demand, shift the demand curve to the left to D2 from D1. This illustrates a fall in the U.S. demand for zee at various price levels in dollars. The new intersection with the supply curve (S) is at Point E2.

Maintain Equilibrium with Fixed Exchange Rates

In a fixed-exchange-rate system, to maintain the exchange rate at 5 dollars per zee despite a decline in demand, the U.S. could increase the supply of dollars in the foreign exchange market. This would be achieved by selling dollars and buying zee to shift the supply curve S to S1, so it intersects the demand curve D2 at the original price level.

Flexible Exchange Rates Adjustment

Under a flexible exchange rate system, the decline in demand for zee causes a surplus in the balance of payments, as the originally planned purchase of U.S. goods and services with zee declines. The exchange rate would then adjust automatically, typically by an appreciation of the dollar against zee until the market is balanced again.

Key concepts

Fixed Exchange Rate System

Imagine a world where exchange rates are as steady as a rock. That's the fixed exchange rate system in a nutshell. In this system, a country's currency is tied to another significant currency or a basket of currencies. The government or central bank commits to maintaining the currency's value within a narrow band, despite changes in the demand or supply of the currency in foreign exchange markets.

To achieve such stability, governments and central banks employ various tools, such as adjusting interest rates, limiting foreign currency purchases, or intervening directly in the market. Intervention often involves buying or selling foreign currency reserves to move the exchange rate back to its desired level.

• It's like having a safety net for currency fluctuation.
• Stability attracts foreign investment due to predictability of exchange rates.
• Can result in economic imbalances if maintained artificially for too long.

The challenge with fixed exchange rates is maintaining the rate through economic volatility, which might not reflect the true market conditions. This requires countries to hold significant foreign currency reserves to counteract market forces when needed.

Flexible Exchange Rate

Unlike its fixed counterpart, a flexible exchange rate can float freely, driven by the forces of supply and demand in the foreign exchange market. This system, also known as a floating exchange rate, allows the currency to find its own value based on economic conditions.

In a flexible exchange rate system, the balance of supply and demand determines the currency's price at any given time. For instance, if demand for a country's exports rises, its currency might appreciate as buyers need more of that currency to pay for goods.

• The currency can appreciate or depreciate without government intervention.
• Let's market dynamics dictate currency valuation naturally.
• Helps countries absorb external shocks without draining reserves.

However, flexibility also means potential instability. Rapid changes can affect trade competitiveness and create uncertainty. But for many, the ability to adjust to economic shifts without intervention is a fair trade-off.

Foreign Exchange Market

The foreign exchange market, often called the Forex market, is the grand arena where currencies are exchanged. This marketplace is unique as it operates globally, 24 hours a day, accommodating various participants from small investors to large financial institutions.

This market determines exchange rates for every currency against others. The rates fluctuate constantly, influenced by factors such as interest rates, economic indicators, and geopolitical events. In the Forex market, currencies are traded in pairs, like USD/EUR or USD/ZEE, with the former being the base currency.

• Currencies traded globally, not confined to a single country.
• It's the largest, highly liquid financial market worldwide.
• Exchange rates change based on market conditions and speculations.

The Forex market can respond quickly to economic changes and remains a key indicator of global economic health. For students analyzing exchange rates, understanding Forex dynamics is essential for grasping economic principles.

Balance of Payments

The balance of payments is an accounting statement that summarizes a country's economic transactions with the rest of the world over a period. This balance consists of three components: the current account, the capital account, and the financial account.

The current account covers goods and services, while the capital and financial accounts document capital transfers and investments. If a country imports more than it exports, it runs a current account deficit, impacting the currency's demand in the foreign exchange market.

• Records all monetary transactions between residents and non-residents.
• Indicates the economic strength of a country.
• Surpluses and deficits influence currency values and economic policies.

When the demand for "zee" falls, resulting in a surplus in the U.S. balance of payments, the exchange rate would adjust in a flexible exchange rate system. Such adjustments balance international trade and investment flows. Understanding the balance of payments can reveal much about a country's economic stature and stability.