In practice, if the economic development vector of the usa and the European Union change,

then everything concerning exchange rate relationship will occur quite on the contrary. This relationship

came into being in the first half of 2003 when the Euro rate rose greatly in relation to the dollar.

Flexible Rates and the Balance o f Payments (Part II)

Flexible rates automatically adjust so as eventually to eliminate balance of payments deficits or

surpluses. We can explain this by looking at SS and DD in Figure 3 which merely restate the demand

for and supply of pounds curves from Figure 9.2. The resulting equilibrium exchange rate,

e.g. of $1.5 = ￡1, correctly suggests that there is no balance of payments deficit or surplus. At the

$1.5 = ￡1 exchange rate the quantity of pounds (the Euro) demanded by Americans in order to

Import British (European) goods, buy British transportation and insurance services, and to pay

Interest and dividends on British (European) investments in the United States is equal to the amount

of pounds (the Euro) supplied by the British in buying American exports, purchasing services from

Americans, and making interest and dividend payments on American investments in Britain. More

succinctly, there would be no change in official reserves.

Now let us suppose there is a change of tastes such that Americans decide to buy more British

automobiles. Or we might assume that the American price level has increased relative to Britain

Figure 9.2. Adjustments under flexible exchange rates, fixed exchange rates, and the gold standard

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(Europe) or that interest rates have fallen in the United States as compared to Britain (Europe).

Any or all of these changes will cause the American demand for British pounds (the Euro) to

increase from DD to, say, D’D’in Figure 3. We observe that at the initial $1.5 = ￡1 exchange rate an

American balance of payments deficit has been created in the amount ab. That is, at the $1.5 = ￡1

rate there is a shortage of pounds in the amount ab to Americans. American export-type transactions

will earn xa pounds, but Americans will want xb pounds to finance import-type transactions.

Because this is a free competitive market, the shortage will change the exchange rate (the dollar

price of pounds) from $1.5 = ￡1 to, say, $2.25 = ￡1; that is, the dollar has depreciated.

At this point it must be emphasized that the exchange rate is a very special price which links all

domestic (American, Russian, Japanese, etc.) prices with all foreign (Britain, European Union, Russia,

Japan, etc.) prices. A change in the exchange rate, therefore, alters the prices of all British

(European, Russian, Japanese, et,c.) goods to Americans and all American goods to potential buyers

In other countries. Specifically, this particular change in the exchange rate will alter the relative

attractiveness of appropriate imports and exports in such a way as to restore equilibrium in the

balance of payments of the country (nation).

In short, the free fluctuation of exchange rates in response to shifts in the supply of and demand

for foreign monies automatically corrects balance of payments deficits and surpluses.

Though freely fluctuating exchange rates automatically tend to eliminate payments imbalances,

they may entail several significant problems; the main ones are:

Uncertainty and diminished trade. The risks and uncertainties associated with flexible exchange

rates may discourage the flow of trade. To illustrate: Suppose an American automobile dealer contracts

to purchase ten Toyota cars for 18 billion yen. At the current exchange rate of, say, $1 for

100 yen, the American importer expects to pay $180,000 for these automobiles. But if in the threemonth

delivery period the rate of exchange shifts to $1 for 90 yen, the 18 billion yen payment

contracted by the American importer will now amount to $198,000, i.e. 10 percent increase. This

unheralded increase in the dollar price of yen may easily turn the potential American importer’s

anticipated profits into substantial losses.

The same rationale applies to investment. Investment is inherently risky. The added risk posed

by adverse changes in exchange rates may persuade the potential investor to shy away from overseas