Under a floating exchange rate system, the exchange rate between currencies is determined by foreign exchange market forces of supply and demand. Under a fixed exchange rate system, a government sets the exchange rate. When there is a surplus of foreign exchange under a fixed system, the central bank must purchase the surplus to increase the money supply. When there is a shortage, the central bank must sell foreign exchange to decrease the money supply. The document discusses the advantages and disadvantages of fixed and floating exchange rate systems for businesses and governments.

1. Exchange Rates Chapter #17 EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

2. Floating Exchange Rate Under the floating exchange rate system, the exchange rate between the domestic currency and the foreign currency is determined by the demand and supply in the foreign exchange market. EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

3. Floating Exchange Rate in Jamaica EDWARD BAHAW - Economic Principles and Their Application to Business (ABE) S S D Jam$/US$ E Q E Quantity of US dollar traded D Jam$40 = US$1

4. Floating Exchange Rate All outflows in the balance of payments create demand for foreign currency . The supply of foreign currency arises from all inflows of foreign exchange in the balance of payments . EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

5. An increase in demand for foreign exchange in Jamaica EDWARD BAHAW - Economic Principles and Their Application to Business (ABE) S S D 1 D 1 D 2 D 2 E 1 E 2 Q 1 Q 2 Jam$/US$ Jam$40 = US$1 Jam$50 = US$1 Quantity of US dollar traded

6. A decrease in demand for foreign exchange in Jamaica EDWARD BAHAW - Economic Principles and Their Application to Business (ABE) S S D 1 D 1 D 2 D 2 E 2 E 1 Q 1 Q 2 Jam$/US$ Jam$40 = US$1 Jam$30 = US$1 Quantity of US dollar traded

7. A decrease in supply of foreign exchange in Jamaica EDWARD BAHAW - Economic Principles and Their Application to Business (ABE) D D S 1 S 1 S 2 S 2 E 1 E 2 Q 1 Q 2 Q US$ Jam$/US$ Jam$40 = US$1 Jam$50 = US$1

8. An Increase in supply of foreign exchange in Jamaica EDWARD BAHAW - Economic Principles and Their Application to Business (ABE) D D S 1 S 1 S 2 S 2 E 2 E 1 Q US$ Q 1 Q 2 Jam$40 = US$1 Jam$30 = US$1 Jam$/US$

9. The Fixed Exchange Rate Under the fixed exchange rate system, the exchange rate is set by the Government In Barbados for instance, a fixed exchange rate is adopted with the United States dollar where Bds$2 = US$1. If the official rate coincides with the equilibrium rate in the foreign exchange market, then there is no need for government intervention. EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

10. The Fixed Exchange Rate EDWARD BAHAW - Economic Principles and Their Application to Business (ABE) D D S S Official Rate Bds$2 = US$1 Q US$

11. Fixed Exchange Rate and a Surplus in the Foreign Exchange Market D 1 D 1 S S Official Rate E 1 Bds$2 = US$1 Bds$1 = US$1 Bds$/US$ Q US$ Q S Q D Surplus EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

12. Increase in Money Supply under a Fixed Exchange Rate D 1 D 1 S S D 2 D 2 Official Rate E 1 E 2 Bds$2 = US$1 Bds$1 = US$1 Bds$/US$ Q US$ Q D = Q S Jamaican Central Bank must purchase the surplus foreign exchange from the market . This causes an increase in the money Supply EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

13. Fixed Exchange Rate and a Shortage in the Foreign Exchange Market EDWARD BAHAW - Economic Principles and Their Application to Business (ABE) D D S 1 Official Rate Q US$ Bds$2 = US$1 Bds$/US$ Bds$3 = US$1 S 1 E 1 Q S Q D Shortage

14. Decrease in Money Supply under a Fixed Exchange Rate D D S 1 Official Rate Q US$ Bds$2 = US$1 Bds$/US$ Bds$3 = US$1 S 1 E 1 S 2 S 2 E 2 Q D = Q S Jamaican Central Bank must sell foreign exchange to the market . This causes a decrease in the money Supply EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

15. Advantages of a Floating Exchange Rate System The exchange rate would adjust to attain equality between exports and imports. No need to manipulate reserves Control over the money supply EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

16. Disadvantages of a Floating Exchange Rate System Speculation Uncertainty Inflation EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

17. Advantages of a Fixed Exchange Rate System Stability Avoid speculation Prevents inflation EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

18. Disadvantages of a Fixed Exchange Rate System The loss of monetary policy The need for a large pool of reserves Current account imbalances EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

19. Expansionary Fiscal Policy and a Floating Exchange Rate Expansionary fiscal policy Decrease in taxes, increase in government spending Income increases Imports increase Exchange rate adjusts EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

20. Contractionary Fiscal Policy and a Floating Exchange Rate Contractionary fiscal policy Increase in taxes, decrease in government spending Income declines Imports decreases Exchange rate adjusts EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

21. Expansionary Monetary Policy and a Floating Exchange Rate Expansionary monetary policy Interest rates decline Income increases Imports increases Exchange rate adjusts EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

22. Contractionary Monetary Policy and a Floating Exchange Rate Contractionary monetary policy Interest rates rise Income declines Imports decreases Exchange rate adjusts EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

23. Contractionary Fiscal Policy and a Fixed Exchange Rate Contractionary fiscal policy Increase in taxes, decrease in government spending Income increases Imports rise Shortage created in foreign exchange market Money supply decreases Interest rate increases Income decreases EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

24. Contractionary Monetary Policy and a Fixed Exchange Rate Contractionary monetary policy Interest rate increases Income declines Imports decreases Surplus of foreign exchange in the market Money supply increases Interest rate falls Income increases EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

25. Expansionary Fiscal Policy and a Fixed Exchange Rate Expansionary fiscal policy Decrease in taxes, increase in government spending Income increase Imports rise Shortage created in foreign exchange market Money supply decreases Interest rate rise Income decreases EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

26. Contractionary Monetary Policy and a Fixed Exchange Rate Contractionary monetary policy Interest rate increases Income declines Imports decreases Surplus of foreign exchange in the market Money supply increases Interest rate falls Income increases EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)

27. Dec 2008 Q6 (a) Discuss the basic differences between fixed and floating exchange rates. (5 marks) (b) Discuss the advantages and disadvantages of fixed and floating exchange rate systems for: (i) a business which engages in international trade; (10 marks) (ii) a government concerned with controlling inflation using fiscal or monetary policy. (10 marks) (Total 25 marks) EDWARD BAHAW - Economic Principles and Their Application to Business (ABE)