14.1 Implications of Budget Deficits

Curiosity 16.1: What Is the Effective Exchange Rate?
Looking at the value of the U.S. dollar in terms of any other single currency can be misleading. It is possible, for example, for the value of the U.S. dollar to rise relative to one currency but at the same time fall relative to another currency. The impact on the balance of payments is not clear. It would depend on how much trade was conducted with each of these countries. A better measure of the U.S. dollar exchange rate is the trade-weighted or effective exchange rate an index calculated as a weighted average of U.S. dollar exchange rates with all other countries, where the weights reflect the proportion of total U.S. trade done with each of these countries.

Under a flexible exchange rate, therefore, the initial reaction of the economy to an imbalance in the balance of payments is a change in the exchange rate, which in turn creates additional forces for change in the economy. If, with other variables constant, the exchange rate rises, demand for our exports falls because foreigners find our exports more expensive in terms of their currency. Furthermore, imports become cheaper to us (because our dollar now buys more foreign exchange), so there is a fall in demand for domestically produced goods and services that compete with imports. Both phenomena imply that aggregate demand for domestically produced goods and services falls.
Similarly, if the exchange rate falls, demand for exports and import-competing goods and services should be stimulated, implying a rise in demand for domestically produced goods and services.
To summarize, if the economy has a flexible exchange rate, an imbalance in the international sector of the economy, measured by the balance of payments, automatically causes the exchange rate to change; this change in turn causes the import-competing and export sectors of the economy to adjust, thus affecting aggregate demand for goods and services.
16.2
International Imbalance With a Fixed Exchange Rate
Under a fixed exchange rate system, the government does not allow the forces of supply and demand to determine the exchange rate. Instead, the government fixes the exchange rate at what it believes is the "right" rate, and the central bank, armed with a stockpile of foreign exchange reserves, stands ready to buy or sell foreign currency at that rate. If there is a balance of payments surplus, the demand for our dollar by foreigners is greater than the supply, so some of these foreigners will seek extra, unavailable dollars. Under a flexible exchange rate, they would have to get dollars by offering more foreign exchange, but under a fixed exchange rate this higher cost can be avoided because the Fed will exchange their foreign currency for dollars at the fixed rate. When the Fed does so, it takes the extra foreign exchange

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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