Financing International Trade

The Real Exchange Rate

The real exchange rate is the relative price of U.S-produced goods and services to foreign-produced goods and services. It tells how many units of foreign GDP one unit of U.S. GDP buys. The real exchange rate, RER, is equal to

RER = (E ´ P)/P*

where E is the nominal exchange rate, P is the U.S. price level, and P* is the foreign price level.

Exchange Rate Policy

Because the exchange rate is the price of a country’s money, governments and central banks must have a policy toward the exchange rate. Three possible exchange rates policies are.

Flexible Exchange Rate

Fixed Exchange Rate

· If the demand for dollars decreases or the supply of dollars increases, to fix the exchange rate the Fed buys U.S. dollars. By so doing the Fed increases the demand for dollars and raises the exchange rate. But the Fed cannot pursue this policy forever because it eventually will run out of the foreign reserves it is using to purchase the dollars.

· In the figure the demand for dollars has decreased from D0 to D1. To keep the exchange rate fixed at 100 yen per dollar, the Fed needs to buy 2 billion dollars per day, the difference between the quantity of dollars supplied at the fixed exchange rate (7 billion dollars per day) and the [new] quantity of dollars demanded (5 billion dollars per day). To purchase these dollars the Fed must use its foreign reserves. Ultimately the Fed will run out of foreign reserves and when that takes place the Fed can no longer peg the exchange rate at 100 yen per dollar.

· If the demand for dollars increases or the supply of dollars decreases, with no intervention the exchange rate will rise. To fix the exchange rate the Fed sells U.S. dollars so that it increases the supply of dollars and lowers the exchange rate. But the Fed will accumulate large stocks of the foreign reserves it is accepting in payment for the dollars. The People’s Bank of China pursued such a policy to hold down the value of the yuan and while so doing accumulated billions of dollars of U.S. dollars.

The Crawling Peg Policy

A crawling peg policy selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate only the target value changes. The target changes whenever the central bank changes. China is now currently using a crawling peg exchange rate policy for the yuan.

53) The People’s Bank of China in the Foreign Exchange Market

Financing International Trade