Floating and Fixed Systems

ª The market for foreign exchange is much like other markets. When a market condition changes, the demand curve, the supply curve, or both can shift creating excess demand or excess supply of the currency. ª If a change creates excess demand or excess supply, the market price, or exchange rate, is bid up or down to equalize demand and supply at a new market equilibrium. In a free market, the system is called a floating exchange rate system. ª Under a fixed exchange rate system, the central bank of a country can decide to maintain a certain exchange rate by buying or selling its foreign exchange.

Under a floating exchange rate system, the market for foreign exchange finds an equilibrium price through the process of bidding up or bidding down the exchange rate until an equilibrium is reached.

In this example, the behavior of Mexicans is represented by the demand curve, and the behavior of Americans is represented by the supply curve.

Examine the example on the left. Under a floating exchange rate system, an increase in demand for dollars creates excess demand in the market at the equilibrium exchange rate of e*. At that exchange rate, there is excess demand for dollars. The bidding process for scarce dollars will bid the equilibrium price up to e**, and the market will find an equilibrium.

Now assume that the supply curve shifts outward. On the left, the shift has created an excess supply of dollars at the equilibrium exchange rate of e*. The bidding mechanism works this time in the opposite direction to eliminate the excess supply and establish a new equilibrium at e**.

Often in the foreign exchange market, both supply and demand curves shift simultaneously. If U.S. interest rates increase, Mexican demand for dollars increases. Supply will fall, however, as Americans also want to invest more in the U.S. The market has a large excess demand for dollars. Under a floating exchange rate system, a new equilibrium will be established at e**. Under a fixed exchange rate system, the central bank of a country can decide that the exchange rate should not be allowed to float. The central bank might decide to keep the rate fixed to prevent the cost of imports from increasing. The bank would use its foreign exchange to buy or sell to keep the exchange rate at e0.

In the example on the left, if demand for dollars increases to D', and if the supply of dollars decreases to S', then the free market exchange rate will be e1. The Mexican central bank wants to keep the exchange rate at e0. It enters the exchange market, sells foreign currency, and forces the supply curve out to S'' to maintain the fixed rate.