Question

When a county faces a downturn in exports, what would be a better exchange rate policy to handle this shock- fixed ER policy or flexible one? Pls explain, using diagrams.

Answer 1

when a country faces a downturn in exports the better exchange policy is a flexible exchange rate policy.This can be cleared with the following example .Let us consider two countries USA and UK.Suppose value of US dollars increases and value of UK pound decreases US consumer will purchase more of UK products .This may cause in turn a low export in US product to other countries,it will increase UK export .The demand for UK pound increases .British made goods and services appear less expensive to US buyers .This will increase gradually the price of pounds ie the pound will appreciate with respect to dollar because of high demand for pound and excess supply of pounds will cause the price of pounds to fall.Again pound will depreciate with respect to dollar.The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied ,this can be seen in the figure.Thus exchange rate which are flexible will bring the downward export to upward.Therefore a flexible foreign exchange rate is beneficial for a country with downturn in export.