Question

Suppose that the Fed is fixing the dollar-pound exchange rate at \(\$ 2.50= £ 1\). If the Fed's reserve of pounds falls by \(£ 500\) million, by how much would the supply of dollars increase, all other things equal?

Short answer

The supply of dollars increases by $1250 million.

Step-by-step solution

Understanding the Fixed Exchange Rate

The fixed exchange rate indicates that 1 pound (£1) is equal to $2.50. This implies that to maintain this rate, the quantity of dollars equivalent to pounds sold must be added to the market by the Fed.

Calculating the Dollar Equivalent

Given that the Fed's reserve of pounds falls by £500 million, we need to find out how many dollars are supplied to the market to maintain the exchange rate. This can be calculated by multiplying the number of pounds with the exchange rate: £500 million × $2.50/£1.

Performing the Multiplication

Perform the multiplication: £500 million × $2.50 = $1250 million. This calculation shows the total dollar amount supplied.

Key concepts

Fixed Exchange Rate

A fixed exchange rate is an official exchange rate set by a country's monetary authorities against another currency or a basket of currencies. Unlike a floating exchange rate, it does not fluctuate with market forces. The aim here is to provide stability in international prices, which can foster trade and investment with certainty about foreign exchange costs. When a government pegs its currency at a fixed rate to another currency, it often means regularly intervening in the foreign exchange market.

This intervention involves buying or selling currencies to keep the exchange rate at its target level. For instance, if the Fed decides to fix the dollar-pound exchange rate at $2.50 per pound, it ensures that one pound always equals $2.50. This setup can lead to economic stability by eliminating the risk of extreme exchange rate fluctuations.

However, fixed exchange rates can also require large reserves of foreign currency to defend the peg, resulting in significant costs for the maintaining country. Despite these challenges, a fixed exchange rate remains a tool for managing a country's monetary policy and trade relationships.

Foreign Exchange Reserves

Foreign exchange reserves are assets held by a country's central bank in foreign currencies. They serve as a tool for stabilizing the currency, facilitating international trade, and managing the country's external debt. Reserves are typically comprised of foreign currencies like dollars, euros, or yen, as well as special drawing rights (SDRs) and gold.

When a country maintains a fixed exchange rate, as seen in the Fed's decision in our example, it must hold substantial foreign reserves to ensure it can buy or sell the currency to maintain the desired rate. If the Fed's pound reserves diminish significantly, the ability to uphold the fixed rate could be compromised.

This reliance on currency reserves highlights the crucial role these reserves play. They act as a buffer, providing the central bank with the ability to sustain the fixed exchange rate even during periods of market pressure or economic uncertainty.

Currency Supply

The supply of a currency refers to the total amount of that currency available in the market at any given time. In a fixed exchange rate system, managing currency supply is essential to maintain the peg. If a central bank wants to keep its currency value stable against another, it must control how much of its currency is in circulation.

In the context of our problem, the Fed increased the supply of dollars in the foreign exchange market by $1.25 billion to maintain the dollar-pound rate at $2.50. To do this effectively, it might involve selling dollars from its reserves. By increasing the supply of dollars, it meets the demand created when its foreign reserves, like pounds, decrease.

This action illustrates how currency supply directly affects exchange rates and is a tool used by central banks to influence monetary conditions. Adjusting the supply allows the central bank to stabilize or affect the currency's value in foreign exchange markets.

International Economics

International economics is the study of how countries interact with one another economically. It covers aspects like international trade, foreign direct investment, and exchange rates. Exchange rates, specifically, are crucial as they determine how much of one currency can be exchanged for another.

A fixed exchange rate, such as in the Fed's example, can influence international economics significantly. It impacts international trade by providing predictable conversion rates, which helps businesses plan and price their goods and services accordingly. Without worries about fluctuating costs, cross-border economic activities become smoother and potentially more profitable.

Furthermore, international economics examines the role of institutions like the IMF in providing assistance to countries managing fixed exchange rate systems. By understanding how these various elements connect in the global economic framework, policymakers can make informed decisions aimed at promoting stable economic growth.