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Chapter Review Chapter 34: The International Financial System

  1. In a flexible exchange rate system, exchange rates are determined in the foreign exchange market by the forces of supply and demand.
  2. The demand for and supply of dollars are determined by exports and imports, by foreigners’ desire to invest in the United States and Americans’ desire to invest abroad, and by speculators who base their demands for various currencies on expectations about changes in future exchange rates.
  3. In the absence of foreign borrowing and lending, exports and imports would always need to balance.
  4. A rise in interest rates will attract a capital inflow and cause the exchange rate to rise; a fall in interest rates will cause the exchange rate to fall.
  5. Under a fixed exchange rate system, the government must intervene in the foreign exchange market to ensure that demand and supply balance at the pegged exchange rate.
  6. In a small open economy with perfect capital mobility, under a fixed exchange rate system the domestic interest rate must equal the foreign interest rate. Monetary policy therefore must be used to peg the exchange rate and cannot be used to address other macroeconomic goals.
  7. It may not be possible for the government to stabilize exchange rates effectively. It is difficult to determine the equilibrium exchange rate that is supposed to be stabilized, and international coordination may not be achievable.
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