Adjustment Mechanism Economics

Adjustment Mechanism Economics

1. Fixed exchange rate system: Fixed or pegged exchange rate system refers to a system in which exchange rate of a country’s currency is fixed to another country’s currency or the price of gold by the government or the central bank. The basic purpose of adopting this system is to ensure stability in balance of payments. To achieve stability monetary authority buy foreign currency when the exchange rate becomes weaker and sell foreign currency when the exchange rate get stronger.

   Under the gold standard, the currency in used was made a of gold or was convertible into gold at a fixed rate

   A deficit or surplus in balance of payment was automatically adjusted under gold standard by the price specific flow mechanism. For instance a deficit in balance of payment meant a fall in the foreign exchange reserves of the country due to an outflow of gold to a surplus country. This reduce the country’s money supply thereby declining to price level. This in turn would increase the exports and reduce its imports. This adjustment process was supplemented by a rise in interest rate lead to inflow of short capital and restoring balance of payment equilibrium. Monetary authority may fixed the exchange rate by a intervention in the currency market. The fixed exchange rate system is explained with the help of a figure

   In the figure D and S are the demand and supply curve of dollar. They determined the exchange rate at point E which the authority maintains suppose the demand for dollars is more than their supply as shown in figure PP_/ given the supply. This leads to rise in exchange rate to E₂. To maintain the exchange rate at the fixed level E, the monetary authority will continue to supply dollars to the market tell the exchange rate E is reached. In the opposite case, if there is excess supply, PP_/ in figure, given the demand, the exchange rate falls to E₁. To maintain the exchange rate at E the monetary authority will start to buy dollars been the market till the exchange rate E is reached.

2. Flexible exchange rate system: The disequilibrium in balance of payment under flexible exchange rate is automatically solved by the forces of demand and supply for foreign exchange. This is automatically achieved by a depreciation (or appreciation) of a country’s currency in case of a deficit (or surplus) in its balance of payment. Depreciation (or appreciation) of a country means that its relative value decreases (or increase). Depreciation has the effect of encouraging exports and discouraging imports.

Assumptions:

(i) There are two countries Britain and U.S

(ii) Both are flexible exchange rate system.

(iii) Balance of payment disequilibrium is automatically adjusted by changes in exchange rate.

(iv) Prices are flexible in both the countries.

(v) There is free trade between the two countries.

Given this assumption the adjustment process is explained with the help of a figure

In the figure D is the US demand curve of foreign exchange representing its demand for british imports and S is the supply curve of foreign exchange representing its exports to Britain. At point P, demand and supply of the US foreign exchange is in equilibrium where the rate of exchange between US dollar and british pound id OE and quantity of exchange is OQ Suppose disequilibrium takes place in the balance of payments of the US in relation to Britain. This disequilibrium is shown by a shift in the demand curve from D to D₁ and deficit equals to PP₂.

This means an increase in US demand for british pound. The implies depreciation of the U.S. dollar and appreciation of the british pound. As a result import prices of import goods rise in the US and the prices of US exports fall. This leads to a new equilibrium point P₁ and a new exchange rate OE₁. The demand for foreign exchange equals the supply of foreign exchange at OQ₁ and the balance of payments is in equilibrium.

On the other hand, the higher price of british goods in terms of dollars tends to reduce demand for british goods and increasing the demand for domestic goods in the U.S. This leads to the movement from P₂ to P₁ along the new demand curve D₁. Thus, the initial deficit PP₂ in balance of payment is removed by increased in the foreign exchange supplied QQ₁ and decrease in the foreign exchange demanded by Q₂Q₁ so that balance of payment equilibrium is achieved at the exchange rate OE₁ whereby OQ₁ foreign exchange is supplied and demanded.

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