Chapter 23: Problem 5

Analyse the determination of the supply of foreign exchange in a flexible or floating exchange rate system.

Short Answer

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Question: Explain the factors that influence the supply of foreign exchange in a flexible exchange rate system. Answer: The supply of foreign exchange in a flexible exchange rate system is determined by three main factors: exports, capital inflows, and indirect central bank interventions. 1. Exports: When a country exports goods and services, it receives payments in foreign currency, increasing the supply of foreign exchange. Factors influencing exports include price competitiveness, product quality, diversification, and trade agreements. 2. Capital Inflows: Investments made by foreign investors in the domestic market, such as foreign direct investment (FDI) and portfolio investment, contribute to the supply of foreign exchange as investors bring in foreign currency for their investments. Factors that influence capital inflows include macroeconomic stability, investment climate, and investment opportunities. 3. Indirect Central Bank Interventions: Although central banks in a flexible exchange rate system do not actively intervene to fix the exchange rate, they can indirectly influence the supply of foreign exchange through monetary policy actions such as interest rate adjustments that affect the investment decisions of foreign investors. Higher interest rates can attract more capital inflows, increasing the foreign exchange supply, while lower interest rates may have the opposite effect.

Step by step solution

Understand the concept of flexible exchange rate system

A flexible or floating exchange rate system is a system in which the value of a currency, in terms of another currency, is determined by the market forces of supply and demand. In this system, the central bank does not intervene to fix the exchange rate and allows the currency value to fluctuate with the market conditions.

Examine the factors influencing the supply of foreign exchange

In a flexible exchange rate system, the supply of foreign exchange is determined by three main factors: exports, capital inflows, and central bank interventions. Let's discuss each of these factors: - Exports: When a country exports goods and services, it receives payments in foreign currency. The increase in exports leads to an increase in the supply of foreign exchange. - Capital Inflows: Capital inflows involve investments made by foreign investors in the domestic market. These investments can be in the form of foreign direct investment (FDI), portfolio investment, or other types of financial investments. Capital inflows increase the supply of foreign exchange as the foreign investors bring in the foreign currency to make investments. - Central Bank Interventions: In a flexible exchange rate system, the central bank does not actively intervene to fix the exchange rate, but it can still indirectly influence the supply of foreign exchange through its monetary policy actions that affect interest rates.

Analyze the role of exports in supplying foreign exchange

The export sector plays a crucial role in the determination of foreign exchange supply. When a country exports goods and services, the foreign buyers make payments in their domestic currency or in an internationally accepted currency (e.g., US dollars). This leads to an increase in the supply of foreign exchange. In this analysis, it is essential to look at the factors that influence the export performance of a country, such as price competitiveness, product quality, diversification, and trade agreements.

Assess the impact of capital inflows on the foreign exchange supply

Capital inflows, such as foreign direct investment (FDI) and portfolio investment, contribute to the supply of foreign exchange in a country. Foreign investors purchase domestic assets or undertake investments in the domestic market using foreign currency, increasing the supply of foreign exchange. The factors that influence capital inflows include the macroeconomic stability of a country, the investment climate, and the attractiveness of investment opportunities. Higher capital inflows can lead to a higher supply of foreign exchange and vice versa.

Understand the indirect role of central banks in the foreign exchange supply

While central banks in a flexible exchange rate system do not actively intervene to fix the exchange rate, they can still indirectly influence the supply of foreign exchange through monetary policy actions. For example, by setting interest rates, the central bank can affect the investment decisions of foreign investors. Higher interest rates may attract more capital inflows, leading to an increase in the foreign exchange supply, while lower interest rates may have the opposite effect. In conclusion, the supply of foreign exchange in a flexible exchange rate system is determined by a combination of export performance, capital inflows, and central bank's monetary policy decisions. Each of these factors plays an essential role in providing the foreign currency needed for international transactions, and understanding their dynamics is crucial in analyzing the determination of foreign exchange supply in a floating exchange rate system.