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The price adjustment Mechanisms with Flexible and Fixed Exchange Rates

Under flexible (or floating) exchange rates, the disequilibrium in the balance of payments is automatically solved by the forces of demand and supply for foreign exchange. An exchange rate is the price of a currency which is determined, like any other commodity, by demand and supply. “The exchange rate varies with varying supply and demand conditions, but it is always possible to find an equilibrium exchange rate which clears the foreign exchange market and creates external equilibrium.”

This is automatically achieved by a depreciation (or appreciation) of a country’s currency in case of a deficit (or surplus) in its balance of payments. Depreciation (or appreciation) of a currency means that its relative value decreases (or increases). Depreciation has the effect of encouraging exports and discouraging imports.

When exchange depreciation takes place, foreign prices are translated into domestic prices. Suppose the dollar depreciates in relation to the pound. It means that the price of dollar falls in relation to the pound in the foreign exchange market.

This leads to the lowering of the prices of U.S. exports in Britain and raising of the prices of British imports in the U.S. When import prices are higher in the U.S., the Americans will purchase less goods from the Britishers. On the other hand, lower prices of U.S. exports will increase their sales to Britain. Thus the U.S. exports will increase and imports diminish, thereby bringing equilibrium in the balance of payments.

It’s Assumptions:

  1. There are two countries Britain and U.S.
  2. Both are on flexible exchange rate system.
  3. BOP disequilibrium is automatically adjusted by changes in exchange rates.
  4. Prices are flexible in both the countries.
  5. There is free trade between the two countries.

Explanation:

Given these assumptions, the adjustment process is explained in terms of Figure 1 where D is the U.S. demand curve of foreign exchange representing its demand for British imports, and S is the U.S. supply curve of foreign exchange representing its exports to Britain. At P the demand and supply of the U.S. foreign exchange is in equilibrium where the rate of exchange between U.S. dollar and British pound is OE and the quantity of exchange is OQ.

F1-theintactone.jpg

Suppose disequilibrium develops in the balance of payments of the U.S. in relation to Britain. This is shown by a shift in the demand curve from D to D1 and the incipient deficit equals PP2. This means an increase in the U.S. demand for British imports which leads to an increase in the demand for pound. This implies depreciation of the U.S. dollar and appreciation of the British pound. As a result, import prices of British goods rise in the U.S. and the prices of U.S. exports fall.

This tends to bring about a new equilibrium at P1 and a new exchange rate at OE1 whereby the deficit in the balance of payments is eliminated. The demand for foreign exchange equals the supply of foreign exchange at OQ1 and the balance of payments is in equilibrium.

When the exchange rate rises to OE1, U.S. goods become cheaper in Britain and British goods become expensive in U.S. in terms of dollar. As a result of changes in relative prices, the lower prices of U.S. goods increase the demand for them in Britain, shown by the new demand curve D1.

This tends to raise the U.S. exports to Britain which is shown as the movement from P to P1along the supply curve S. At the same time, the higher price of British goods in terms of dollars tends to reduce demand for British goods and to switch demand to domestic goods in the U.S. This leads to the movement from P2 to P1 along the new demand curve D1.

Thus the incipient deficit PP2 in BOP is removed by increase in the foreign exchange supplied by QQ1 and decrease in the foreign exchange demanded by Q2Q1 so that BOP equilibrium is achieved at the exchange rate OE1 whereby OQ1 foreign exchange is supplied and demanded.

The above analysis is based on the assumption of relative elasticities of demand and supply of foreign exchange. However, in order to measure the full effect of depreciation on relative prices in the two countries, it is not sufficient for demand and supply conditions to be relatively elastic.

What is important is low elasticities of demand and supply of foreign exchange. This is illustrated in Figure 2 where the original less elastic demand and supply curves of foreign exchange are D and S respectively which intersects at P and the equilibrium exchange rate is OE. Now a deficit in the balance of payments develops equals to PP2.

f2-theintactone.jpg

Since the elasticities of demand and supply of foreign exchange are very low (inelastic), it requires a very large amount of depreciation of the dollar and the appreciation of the pound for the restoration of the equilibrium.

The equilibrium will be established through relative price movements in the two countries, as explained above, at P1 with a very high rate of foreign exchange OE1. But such a high rate of depreciation would lead to very high price changes in the two countries thereby tending to disrupt their economies.

FIXED EXCHANGED RATES

Merits:

  1. Under a fixed exchange rate regime, speculative movements of capital- one of the major causes of economic crises and instability are more or less ruled out.
  2. Variability of exchange rate is an important source of uncertainty associated with international trading. A fixed rate of exchange eliminates this source of uncertainty.

Demerits:

(i) The conditions under which automatic adjustment mechanism of gold standard operate are very difficult to meet.

In particular, theoretical assumptions relating to highly competitive structure of the trading economies, full application of the quantity theory of money, non-interference by the authorities, and high price elasticities of both demand and supply are not found in real-life situations.

(ii) The main thrust of adjustment is borne by domestic prices, income and employment etc. Stability of exchange rate is given preference over domestic stability of income and employment.

(iii) Because of their poor economic strength, most developing countries find it difficult to pursue a policy of fixed exchange rates. They are often compelled to restructure their economies on account of their limited role in international trade and capital flows.

Most of them also suffer from other forms of economic weaknesses as well including, for example, institutional rigidities, insufficient foreign exchange reserves, and so on.

(iv) For ensuring economic stability and a reasonable protection from disturbances originating in foreign countries, fixed exchange rates regime requires supplementary measures by the authorities.

(v) Fixed rate of exchange does not remove the basic causes of balance of payments disequilibrium particularly when the trading economies are not resilient enough and/or their markets structures are not highly competitive.

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