Reflective Exercise: Joining the Euro: the effect on the exchange rate 5
Feedback Section 1 (continued): Part D
Now review your answers in the light of the economists’ approach below.
Were your answers the same? If not, how did they differ?
Comparing fixed and floating exchange rate mechanisms
D
Put a cross by however many of the following you think appropriate
a If the exchange rate is floating, the exchange rate automatically X
appreciates to £1:€1.6.
b If the exchange rate is fixed the exchange rate automatically stays at
£1:€1.5 without any intervention by the monetary authorities.
c If the exchange rate is fixed there will an excess demand of £s of N1-N3. X
d If the exchange rate is fixed there will an excess demand of £s of N2-N3.
e If the exchange rate is floating, the exchange rate will stay at £1:€1.5 as
market pressures will automatically reduce the demand curve back to its
original position.
f The number of pounds demanded will be the same under fixed and
floating exchange rates; it will only be the exchange rate that differs.
D Comparing fixed and floating exchange rate mechanisms
Under a floating exchange rate the market mechanism is allowed to work freely and
the excess demand caused by the shift in the demand curve will be eliminated by
the appreciation in the exchange rate, so (a) is correct.
These market forces are still at work under a fixed exchange rate and so this will not
automatically stay at £1:€1.5, but it requires the Bank of England to provide the extra
supply of £s. (It exchanges £s for foreign currency, adding to the nation’s reserves.)
The excess demand is N1-N3 if the exchange rate is fixed and the number of pounds
is N3 (i.e. (c) is correct, not (d)). This is not the same number as under floating
exchange rates, as in that case the increase in the exchange rate lowers the
quantity demand (to N2) through the movement along the demand curve.
Notice the way we refer to the points on the axis in our answer – this is important
because it is what we are drawing the diagram to find out.
Figure 1: The foreign exchange market
Things to look for on the
↑
diagram:
Appreciation
S • the labelling of the axis
• the initial equilibrium
• the disequilibrium caused
Exchange rate
£1:€1.6
by the shift in demand
£1:€1.5 •the new equilibrium with a
floating exchange rate
D2
D1
N1 N2 N3
Numbers of pounds (£s)
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Joining the Euro: the effect on the exchange rate 6
Feedback Section 1: Setting the framework
D Comparing fixed and floating exchange rate mechanisms
Under a floating exchange rate the market mechanism is allowed to work freely and
the excess demand caused by the shift in the demand curve will be eliminated by
the appreciation in the exchange rate, so (a) is correct.
These market forces are still at work under a fixed exchange rate and so this will not
automatically stay at £1:€1.5, but it requires the Bank of England to provide the extra
supply of £s. (It exchanges £s for foreign currency, adding to the nation’s reserves.)
The excess demand is N1-N3 if the exchange rate is fixed and the number of pounds
is N3 (i.e. (c) is correct, not (d)). This is not the same number as under floating
exchange rates, as in that case the increase in the exchange rate lowers the
quantity demand (to N2) through the movement along the demand curve.
Notice the way we refer to the points on the axis in our answer – this is important
because it is what we are drawing the diagram to find out.
On to Section 2
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.