Page 207 - Encyclopedia of Business and Finance

eobf_C 7/5/06 2:57 PM Page 184

Currency Exchange

Money traders in Tokyo AP IMAGES

FIXED- VERSUS FLEXIBLE- and demand more yen. In the absence of intervention by
EXCHANGE-RATE SYSTEMS a central bank, the exchange rate would change. In order
Under the flexible-exchange-rate system, the equilibrium to maintain the foreign-exchange price of the yen, the
exchange rate reflects the supply and demand for the cur- Japanese central bank would buy (demand) dollars and
rency. Under a fixed-exchange-rate system, a country’s sell (supply) yen.
central bank intervenes by buying or selling its currency to If the central bank did not act to support the stated
keep its foreign-exchange rates from changing. As with foreign-exchange rate, then too much or too little of one
most systems in which the price of a good or service is currency would be supplied or demanded. This lack of
fixed, the only way that it can remain so is for the govern- balance (i.e., disequilibrium) in the foreign-exchange mar-
ment to intervene. Consider the two-country example ket would impede trade between the two countries and
above. Suppose that there were an increase in the prices of could potentially result in a black market (i.e., under-
all goods and services made in the United States, includ- ground market or illegal trade) in the two currencies.
ing steel. The Japanese yen would now buy less steel than
before. The Japanese would supply fewer yen to the CURRENCY CRISES
foreign-exchange market and demand fewer dollars at the The only way for the United States to support the price of
fixed exchange rate. However, suppose Americans contin- the dollar is to buy up excess dollars with foreign
ued to demand Japanese cars. In fact, they would demand reserves—in our case, with Japanese yen. But the United
more Japanese cars because, at the fixed exchange rate, the States might eventually run out of Japanese yen. If this
relative price of Japanese cars would fall. Americans would happened, it would no longer be able to stabilize the price
now supply more dollars to the foreign-exchange market of the dollar, and a currency crisis would result. A cur-

184 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION