Chapter 10
Exchange Rates and Exchange
Rate Systems
◼ Outline
Introduction: Fixed, Flexible, or In-Between?
Exchange Rates and Currency Trading
Reasons for Holding Foreign Currencies
Institutions
Exchange Rate Risk
The Supply and Demand for Foreign Exchange
Supply and Demand with Flexible Exchange Rates
Exchange Rates in the Long Run
Exchange Rates in the Medium Run and Short Run
Case Study: The Largest Market in the World
The Real Exchange Rate
Alternatives to Flexible Exchange Rates
Fixed Exchange Rate Systems
Case Study: The End of the Bretton Woods System
Choosing the Right Exchange Rate System
Case Study: Monetary Unions
Single Currency Areas
Conditions for Adopting a Single Currency
Case Study: Is the NAFTA Region an Optimal Currency Area?
Appendix: The Interest Rate Parity Condition
Chapter 10 Exchange Rates and Exchange Rate Systems 63
◼ Learning Objectives
After studying this chapter, students will be able to:
10.1 List the reasons for holding foreign exchange and the main institutions in the
foreign exchange market.
10.2 Diagram the effects on the home currency of a change in supply or demand
for foreign currency.
10.3 Differentiate short-run, medium-run, and long-run forces that help determine
the value of a currency.
64 Gerber • International Economics, Seventh Edition
◼ What Students Should Know after Reading Chapter 10
Chapter 10 starts with a principles-level introduction to exchange rates and the determination of the value
of national currencies in the context of simple supply-and-demand analysis. It is worth emphasizing that
the exchange rate is the price of one currency in terms of another, and that it can be measured as either
“units of domestic currency per unit of foreign currency” or its inverse, “units of foreign currency per unit
of domestic currency.” It is both dollars per pound, and pesos per dollar. However, in order to be
consistent in our graphical and algebraic treatments, we need to define it as either one or the other. In this
text, domestic per foreign is used. That simplifies some analysis, but it also makes the meaning of
appreciation and depreciation counterintuitive. Students will need to memorize that an increase in the
exchange rate is a depreciation of the home currency, since it costs more to buy a unit of foreign currency.
I usually introduce the theories of purchasing power parity and interest rate parity (in words rather than
equations) as concepts in this phase to help students understand the long-run versus short-run effects on
flexible exchange rates. We identify a number of factors that might change the demand and/or supply of
currencies given that, depending on the timeframe, ultimately both inflation and real interest rates are
◼ Suggested Assignments
1. Students may be assigned individual nations to make presentations on that country’s exchange rate
with the dollar. They may also collect inflation data and compare that with U.S. data to see if it may
account for some of the exchange rate fluctuations over time. This could also be done as a written
report.
2. It is fairly straightforward to use business periodicals to find current evidence of winners and losers
from exchange rate fluctuations. Students could be asked to find articles on the topic and to provide
some analysis of the impact on a specific firm, industry, or group. For students, this could begin to
connect exchange rate fluctuations to balance of payments.
◼ Answers to End-of-Chapter Questions
Chapter 10 Exchange Rates and Exchange Rate Systems 65
1. Draw a graph of the supply of and demand for the Canadian dollar by the U.S. market. Diagram the
effect of each of the following on exchange rates, state in words whether the effect is long, medium,
or short run, and explain your reasoning.
a. More rapid growth in Canada than in the United States.
b. A rise in U.S. interest rates.
c. Goods are more expensive in Canada than in the United States.
d. A recession in the United States.
e. Expectations of a future depreciation in the Canadian dollar.
Answers:
a. The Canadian supply of currency to the U.S. market increases in response to the rise in Canada’s
demand for American exports. The supply curve shifts right; the U.S. dollar appreciates; the
Canadian dollar depreciates. This effect is medium run because effects of economic expansions
and contractions—the business cycle—on exchange rates run for a few years (usually less than a
66 Gerber • International Economics, Seventh Edition
2. Suppose the U.S. dollar-euro exchange rate is 1.20 dollars per euro, and the U.S. dollar-Mexican peso
rate is 0.10 dollar per peso. What is the euro-peso rate?
3. Suppose the dollar-yen exchange rate is 0.01 dollar per yen. Since the base year, inflation has been
2 percent in Japan and 10 percent in the United States. What is the real exchange rate? In real terms,
has the dollar appreciated or depreciated against the yen?
4. Which of the three motives for holding foreign exchange are applicable to each of the following?
a. A tourist.
b. A bond trader.
c. A portfolio manager.
d. A manufacturer.
Answers:
a. A tourist holds foreign currency to engage in transactions.
5. If U.S. visitors to Mexico can buy more goods in Mexico than they can in the United States when
they convert their dollars to pesos, is the dollar undervalued or overvalued? Explain.
Answer: The dollar is overvalued and the peso is undervalued. The dollar buys “too many” pesos
6. In a fixed exchange rate system, how do countries address the problem of currency market pressures
that threaten to lower or raise the value of their currency?
Answer: Nations must stand ready to counteract shifts in the demand and supply curves for foreign
Chapter 10 Exchange Rates and Exchange Rate Systems 67
7. In the debate on fixed versus floating exchange rates, the strongest argument for a floating rate is that
it frees macroeconomic policy from taking care of the exchange rate. This is also the weakest
argument. Explain.
Answer: Fixed exchange rate systems require the monetary authority to closely monitor the
exchange rate. In effect, the domestic money supply is a captive of the need to maintain
8. Brazil, Argentina, Paraguay, and Uruguay are members of MERCOSUR, a regional trade area that is
trying to become a common market. What issues should they consider before they accept or reject a
common currency?
Answer: The first issue they need to consider is whether or not their business cycles are well
synchronized and whether or not a “one-size-fits-all” monetary policy would satisfy each
member. Conflicts between them will arise if their economies do not contract or expand at
68 Gerber • International Economics, Seventh Edition
Copyright © 2018 Pearson Education, Inc.
the decisions of the Federal Reserve, which conducts monetary policy for the United
States.
9. Suppose that U.S. interest rates are 4 percent more than rates in the EU.
a. Would you expect the dollar to appreciate or depreciate against the euro, and by how much?
b. If, contrary to your expectations, the forward and spot rates are the same, which direction would
you expect financial capital to flow? Why?
Answers:
a. Capital would flow into the United States increasing the supply of foreign exchange. Due to
higher interest rates, investment at home is more attractive than in Europe. This also reduces the
10. Why do some economists claim that the most important feature of any exchange rate system is its
credibility?
Answer: Both flexible and fixed exchange rate systems have advantages and disadvantages. As a
result, no system seems to rank above any other in its ability to provide superior economic
performance. Also, history has proven that a financial crisis can take place whether a