Price adjustments under fixed exchange rate, Microeconomics


In a flexible exchange rate regime trade deficits (surpluses) are automatically corrected by a depreciation (appreciation) of a country's currency. On the other hand, in a fixed exchange rate regime, disequilibrium conditions are corrected by changes in domestic prices. A deficit reduces the country's money supply which in turn reduces the prices. The reduction in the country's money supply will tend to increase the interest rate, which in turn dampens the investment and thereby reduces aggregate demand. Consequently, price level will fall which will encourage exports and discourage imports.

At the same time, higher interest rate induces capital inflows that would help in financing the deficit. he process of price adjustment under the fixed exchange rate regime is similar to that of the price adjustment under the gold standard, i.e., price-specie-flow- mechanism. Under gold standard, a country's currency is defined by the gold content. This is to say that a country will be ready to buy or sell any amount of gold at that price. Further, as the gold content in one unit of currency is fixed, exchange rates will also be fixed. For example, assume that a £1 gold coin in the UK contains 113.0016 grains of pure gold, while a $1 gold coin in the US contains 23.22 grains of gold. This implies that the exchange rate ($/£) is 4.87 (i.e., 113.0016 ÷ 23.22). Assuming no shipping costs,
exchange rate will be stable unless there is a change in the gold reserves of any country. 

This is because no one will be willing to pay more than $4.87 for a £1 coin as gold worth of $4.87 can be purchased in the US and exchange it for £1 in the UK. Similarly gold worth £1 can be purchased in the UK and exchanged for $4.87 in the US. These gold outflows/inflows measure the size of Balance of Payment deficit/surplus. 

In a deficit situation, the automatic adjustment mechanism is as follows: With gold outflows under trade deficit, country's money supply will fall, which in turn, triggers a fall in internal prices. As a result, exports will be encouraged and imports will be discouraged until the deficit in BoP is eliminated. 

This adjustment mechanism operates in a similar manner even if a country is not following a gold standard. The foreign exchange reserves held by a country is akin to the gold reserves. As such, disequilibrium in trade flows will be reflected in the changes in the foreign exchange reserves which in turn influences the money supply and thereby the domestic prices.

Posted Date: 11/10/2012 7:15:37 AM | Location : United States

Related Discussions:- Price adjustments under fixed exchange rate, Assignment Help, Ask Question on Price adjustments under fixed exchange rate, Get Answer, Expert's Help, Price adjustments under fixed exchange rate Discussions

Write discussion on Price adjustments under fixed exchange rate
Your posts are moderated
Related Questions
The goal is to replicate a real life product development and familiarize students with the invent process of a system, component, or process to meet desired wants within realistic

Question 1: a. What is the supposed rationale for subsidising higher education in various developing countries? b. Do you think there is a legitimate rationale to the abov

compare traditional modern and engineering cost curves

how does the concept of possibility production curve aplicable in real life?

Disadvantages of division of labour: Division of labour may also have disadvantages that may include the following: (i) Lack of Craftsmanship Division of labour does not m

Differentiate between real and nominal variables.  In economics, the distinction among nominal and real numbers is often made. Nominal variables -- like nominal wages, interest

Do the laws of economics still work today? use the case discussed in class to answer this question or any other examples) (ii) Provide examples of three factors that can shift the

inflation and policies that are used to combat it