Chapter 17 International Trade and Finance 25 Market Adjustment to Changes in Money Market Conditions By modifying exchange rates to correct for imbalances in payments, the money market can accommodate vast changes in the economic conditions of nations engaged in trade. A good example is the way the market handles a change in consumption patterns. These changes in consumption, and hence in foreign exchange rates, can be caused by changes in a nation’s tastes and preferences, real income, level of prices (including interest rates), costs, and expectations as to future exchange rates. If all countries’ exchange rates move with the relative rates of inflation, only real (terms of trade) changes would affect the relative prices of home country to foreign-country goods. However, while floating exchange rates tend to eliminate automatically any balance-of-payment problems, they may diminish the volume of trade because of the uncertainty and instability of the terms of trade. In fact, since flexible exchange rates were reintroduced in 1971 the volume of world trade has actually grown despite considerable volatility and turbulence. The two major advantages of a floating system are that exchange rates are automatically determined exclusively by free market forces, without government intervention, controls, or regulations. Moreover, external adjustment, under favorable conditions, is attained without requiring major domestic or internal price, income, or employment changes. Its two major disadvantages are: (1) uncertainty and instability in the form of frequent and large fluctuations discourages international trade, transactions, and investment; and (2) there is the possibility of exchange rate fluctuations leading to cumulative disequilibrium rather than stable equilibrium. Suppose American preferences for French goods—say, wines and perfumes— increase for some reason. The demand for francs will rise because Americans will need more francs to buy the additional French goods they desire. If, as in Figure 17.7, the U.S. demand for francs shifts from D 1 to D 2 , the quantity of francs demanded at the old equilibrium exchange rate of ER 1 will exceed the quantity supplied. Those who cannot buy more francs at ER 1 will offer to pay a higher price. The exchange rate will rise toward the new equilibrium level of ER 1 as the equilibrium point shifts from E 1 to E 2. As the dollar depreciates in value, the imbalance in payments is eliminated. _________________________________________ FIGURE 17.7 Effect of an Increase in Demand for Francs An increase in the demand for francs will shift the demand curve from D 1 to D 2 , pushing the equilibrium from E 1 to E 2 . At the initial equilibrium exchange rate ER 1 , a shortage will develop. Competition among buyers will push the exchange rate up to the new equilibrium level ER 2 . Chapter 17 International Trade and Finance 26 Now suppose Americans’ real incomes rise. Assuming that the consumption of goods and services goes up with real income—we called these “normal” goods and services earlier in the book – Americans will be likely to demand more foreign imports, both directly and in the form of domestic goods that incorporate foreign parts or materials. Either way, an increase in real incomes leads to an increase in the demand for foreign currencies. Again the demand for francs will rise, as in Figure 17.7. The exchange rate will rise with it to bring the quantity supplied into line with the quantity demanded. A change in the rate of inflation can have a similar effect on the exchange rate. If the inflation rates are about the same in two nations that trade with each other, the exchange rate between their currencies will remain stable, ceteris paribus, according to the purchasing power parity theory. Because the relative prices of goods in the two nations stay the same, people will have no incentive to switch from domestic to imported goods, or vice versa. If one nation’s inflation rate exceeds another’s, however, the relative prices of foreign and domestic goods change. If prices increase faster in the United States, for example, Americans will want to buy more foreign goods and fewer domestic goods. Foreigners, on the other hand, will have an incentive to buy more goods from their own countries, where prices are not rising as fast as in the United States. In sum, a higher U.S. inflation rate spells a rise in the demand for foreign currencies, a fallen in their supply, and a depreciation of the dollar. Similar flows occur when there are interest rate differentials between nations. Figure 17.8 illustrates the process for prices in general. As U.S. demand for foreign goods rises, the demand curve for francs shifts outward from D 1 to D 2 , shifting the equilibrium from E 1 to E 2 . As foreign demand for U.S. products falls, the supply curve for francs shifts to the left, from S 1 to S 2 . At the initial equilibrium exchange rate of ER 1 , a shortage of francs will develop. The exchange rate will rise to ER 2 , eliminating the shortage and reestablishing balance in the money market. At the higher rate, Americans must pay a higher dollar price for foreign goods. The rise in the exchange rate has evened out the difference in the two nations’ inflation rates. ___________________________________ FIGURE 17.8 Effect of an Increase in Inflation on the Supply and Demand for Francs If the rate of inflation is higher in the United States than in France, the demand for francs will rise from D 1 to D 2 , while the supply of francs will contract from S 1 to S 2 . The dollar price of francs will rise from ER 1 , to ER 2 , as the equilibrium shifts from E 1 , to E 2 . Chapter 17 International Trade and Finance 27 In the short-run, supply and demand are most influenced by anticipations as to the direction in which an exchange rate is likely to move. For example, if the franc is expected to increase in value, people who have payments to make in that currency will tend to buy the currency and make payments sooner. Economic and political news—such as an unanticipated change in monetary policy—has an almost immediate impact. Control of the Exchange Rate: The Fixed or Pegged Rate System So far our analysis of the international money market has assumed a floating, or flexible, system of exchange in which exchange rates are determined by private demand and supply forces in the market. A floating, flexible, or freely fluctuating exchange rate system is one in which the prices of currencies are determined by competitive market forces. Until 1971, however, international exchange rates were controlled by governments. Rates were not permitted to move in response to changes in supply and demand. Because rates were fixed for long periods of time by government decree, this system is generally referred to as a fixed exchange rate system. A fixed or pegged exchange rate system is one in which the prices of currencies are established and maintained by government intervention. Although the fixed-rate system is no longer in use among major nations, it merits some discussion because of its historical importance and because of periodic high-level discussions—especially in the late 1980s—about returning to it. To understand that a properly working fixed exchange rate system can be better than a floating-rate system, consider the problems that would arise if each state in the United States had its own currency. The exchange rate would vary among all the states. The resulting risks and inconveniences would severely hamper interstate trade. For instance, a worker in New York City who commutes from New Canaan, Connecticut, would have to face fluctuating exchange rates on a daily basis when riding subways, buying gas, eating lunch, whatever. The fixed exchange rate has one advantage over the floating rate: it is stable. Because even a small change in the exchange rate can cause significant losses to people who have already concluded business deals, a flexible exchange rate can increase the risks involved in international trade. For example, suppose you agree to purchase cheese at an exchange rate of $0.10 = F1. You promise to pay the exporter $00, and the French cheesemaker expects to receive F5,000. By the time you send the check, however, the rate has moved to $0.11 = F1. The exporter will now receive only F4,545 ($500 ÷ 0.11). She loses F455. If the exchange rate moves in the opposite direction, of course, the exporter will gain. In addition, the French cheesemaker can hedge against short-term losses by agreeing, at the time she closes the deal, to sell the proceeds at a given exchange rate, perhaps a fraction of a cent less than the current rate of $.10 = F1. In long-term deals, however, traders inevitably risk losing money because of changes in exchange rates. Chapter 17 International Trade and Finance 28 They incur a risk cost that is translated into higher prices. Under a fixed-rate system, exchange rates move only periodically. The risk cost is reduced, and the prices of foreign goods can be lower. Like any other form of price control, however, control of foreign exchange rates creates its own problems. If the exchange rate is fixed—at ER 1 in Figure 17.8, for example—and the supply and demand curves remain stable, there is no problem. There is no need for government to fix the rate either, however, It will remain ER 1 as long as the supply and demand curves for currency stay put. Problems can develop when market conditions change but the exchange rate is fixed. If the demand for francs increases from D 1 to D 2 in Figure 17.8, a shortage of francs will develop on the international money market. Those who want francs at the fixed price will be unable to get all they want. The government may have to ration the available francs and police the market against black marketeering. If black markets are not controlled, the price of currency will rise—illegally perhaps, but it will rise nonetheless. In the end, the exchange rate will not really be controlled. Perhaps the chief disadvantage of a fixed rate system is that the level of internal prices and costs in each nation is affected by external economic and monetary developments over which a nation has little or no control. Nations must play according to the rules of the game and submit their internal economy to the dictates of external equilibrium. Concluding Comments The schedule of tariffs applied to goods coming into the United States is now larger than the Los Angeles telephone directory. Surely all those tariffs were not imposed in pursuit of the national interest, as in the maintenance of a strong defense industry. Most probably reflect the political influence of special-interest groups. Yet on balance, the overall tariffs are low, but they mask very high tariffs and even quotas on certain commodities—such as certain agricultural products, tobacco, motorcycles, and cooking utensils. The case against such special-interest tariffs was wittily stated by the nineteenth- century French economist Frederic Bastiat. Pretending to represent the candle manufacturers of his day, he wrote to the French Chamber of Deputies in 1845: Gentlemen: . . .We are subjected to the intolerable competition of a foreign rival, who enjoys, it would seem such superior facilities for the production of light that he is enabled to inundate our national market, at so exceedingly reduced price, that, the moment he makes his appearance, he draws off all customs for us; and thus an important branch of French industry . . . is suddenly reduced to a state of complete stagnation. This rival is no other than the sun. Our petition is, that it would please your honorable body to pass a law whereby shall be directed the shutting up of all windows, doors, skylights, shutters, Chapter 17 International Trade and Finance 29 curtains, in a word, all opening, holes, chinks, and fissures through which light of the sun . . . penetrates into our dwellings. 10 Bastiat suggests that passage of his proposed law would be consistent with the chamber’s attempts to check the importation of “coal, iron, cheese, and goods of foreign manufacture, merely because and even in proportion as their price approaches zero.” Clearly, tariffs force consumers to pay more for domestic goods. In that extent they reduce aggregate real income. Unfortunately because they benefit special-interest groups—tariffs, like other taxes, are probably inevitable. Review Questions 1. Using supply and demand curves, show how a U.S. tariff on a foreign-made good will affect the price and quantity sold in the country of origin. 2. How will an import quota on sugar affect the price of sugar produced and sold domestically? Sugar produced domestically and sold abroad? 3. If a tariff is imposed on imported autos and the domestic demand for autos rises, what will happen to auto imports? If a quota is imposed on imported autos and the demand for autos increases, what will happen to auto imports? 4. Given the following production capabilities for cheese and bread, which nation will export cheese to the other? What might be a mutually beneficial exchange rate for cheese and bread? Cheese Bread France 40 units or 60 units Italy 10 units or 5 units 5. “Tariffs on imported textiles increase the employment opportunities and incomes of domestic textiles workers. They therefore increase aggregate employment and income.” Evaluate this statement. 6. Since the balance of payments must always balance, how can a disequilibrium situation occur? 7. How much would a business spend to get a tariff? What economic considerations will have an impact on the amount? 10 Frederic Bastiat, “A Petition,” Economic Sophisms (Irvington-on-Hudson, N.Y., Foundation for Economic Education, 1964; originally published 1945), purchasing power. 56-60. . Figure 17.8 illustrates the process for prices in general. As U.S. demand for foreign goods rises, the demand curve for francs shifts outward from D 1 to. Americans will be likely to demand more foreign imports, both directly and in the form of domestic goods that incorporate foreign parts or materials. Either