Question

Assume that a floating exchange rate system exists between the United States and Brazil. Note that the currency of the United States is the U.S. dollar, while the currency of Brazil is the Brazilian real. Assume that the inflation rate becomes much higher in the United States, relative to the inflation rate in Brazil. Clearly explain how a floating exchange rate system between the United States and Brazil could compound the problem of high inflation in the United States. Use the countries given in the problem (the United States and Brazil) in your explanation. Clearly explain your logic, using graphs when necessary.

Answer 1

Hi,

Please find my answer as below:

A floating exchange rate is determined by the market through supply and demand. Values fluctuate with market conditions. If demand for a currency is low, value of currency will decrease, thus making imported goods more expensive and stimulating demand for local goods and services.

In case of floating exchange rate, two countries trade goods and services and the value at which investors from one country purchase the assets of another country. As such, it is dependent on the two countries' fundamental macroeconomic conditions, such as its inflation, growth, and saving rates.

The exchange rate arrangement maintained between the United States and its trading partners Brazil. In a floating exchange rate regime, the exchange rate is a price freely determined in the market by supply and demand. The dollar is purchased by Brazilian in order to purchase goods or assets from the United States. Same way, US citizens sell dollars and buy Brazilian real when they wish to purchase goods or assets from Brazil. The exchange rate is determined by whatever rate clears these markets.

When the demand for U.S. goods or assets rises relative to the Brazilian goods and assets, the exchange rate value of the dollar will appreciate. Dollar appreciation accomplishes this through two effects on the United States economy. First, it makes Brazilian goods cheaper for Americans, which increases the purchasing power of American income. This is known as the terms-of-trade effect. Second, it tends to offset the changes in aggregate demand that first altered the exchange rate by making U.S. exports dearer and foreign imports less expensive.

When Brazilian increase their demand for U.S. goods, aggregate demand in the United States increases. If the United States is in a recession, this increase in aggregate demand would boost growth in the short run. If economic growth in the United States is already robust, it would be inflationary—there would be too many buyers (domestic and foreign) seeking the goods that Americans can produce. Domestic economy would be insulated from foreign inflationary pressure in this case.

If there is a depreciation in the exchange rate of US Dollar, it is likely to cause inflation to increase. – (Import prices more expensive). A depreciation means the currency buys less foreign exchange, therefore, imports are more expensive and exports are cheaper.

After a depreciation, we get:

• Imported inflation. The price of imported goods will go up because they are more expensive to buy from abroad.
• Higher domestic demand. Cheaper exports increases demand for US exports. There is also a reduction in demand for imported goods, shifting consumption to domestic goods Therefore, there is an increase in domestic aggregate demand (AD), and we may get demand pull inflation.
• Less incentive to cut costs. Manufacturers who export see an improvement in competitiveness without making any effort. Some argue this may reduce their incentive to cut costs, and therefore, we get higher inflation over the long term.

Hope this helps :)