Fixed Exchange Rates the Aggregate Demand --

Fixed Exchange Rates

The aggregate demand -- aggregate supply accounting identity is

C + I + G + E -- M = GDP.

Under a fixed exchange rate system, the following would occur under expansionary monetary policy. The money supply would increase. This encourages spending, spurring demand from consumers and businesses (C and I). In order to balance this, either government spending would need to decline, or net exports would need to decrease. Assume that government spending remains unchanged. If the country is buying more from overseas and exporting less, then foreign reserves would be depleted in order to pay for those goods.

The first major trade agreement came with the General Agreement on Trade and Tariffs (GATT) in 1948, which was designed to help reduce barriers to the trade in goods. Over time, the GATT became replaced with the World Trade Organization with its successive rounds of negotiations designed to further liberalize trade around the world (WTO, 2011). In Europe, the European Union became a customs union, liberalizing trade among a handful of Western European nations. The Canada-U.S. Free Trade Pact in 1988 was a leader in bilateral agreements, eventually led to NAFTA and since that point bi -- and multi-lateral trade agreements have become commonplace.

Flexible exchange rates are determined by demand for a given country's goods and services, relative to the supply of that country's money. For example, if the price of oil increases, the value of currencies from oil-economy nations will increase because of increased demand for the goods and services of that country. With fixed exchange rates, the rate is pegged to a specific value. For a country to maintain such a peg, it would normally need to buy and sell foreign reserves to hold its currency's value. This can be seen today with China's purchases of U.S. dollar reserves to maintain its peg on the yuan (Panckhurst, et al., 2010). Without such foreign reserve purchases/sales, the fixed rate is likely to deviate from the nature equilibrium point and eventually become unsustainable. This occurred with the Argentine peso in the early 2000s, leading to a collapse of that currency and the Argentine economy.

3. Currency appreciation and depreciation are irrelevant for globalization. Currencies can only move in relation to one another. Thus, one currency's appreciation has a counterbalancing depreciation in another currency. There is no net gain or loss of wealth. Globalization is a complex phenomenon that is driven by dozens of factors. The degree to which trade in particular is globalized is unrelated to marginal changes in any one set of exchange rates. The specific flows of goods or services between any two countries may be affected by exchange rate fluctuations, but the phenomenon of globalization as a whole is driven by a wide range of political and ideological factors and will continue regardless of specific currency movements.

4. The weakening of the U.S. dollar will make U.S. companies more attractive for foreign investors, because it will make the U.S. companies cheaper. The foreign company has a fixed set of assets with which to make purchases of American companies. The value of those assets in the context of purchasing dollar-denominated assets will vary with the exchange rate. If the U.S. dollar becomes weaker, this means that the foreign company's same set of assets can be used to purchase more U.S. assets than under the previous rate. The cheaper dollar-denominated assets become to overseas investors, the more overseas investors will be encouraged to purchase those assets, as the return on investment will improve as the total value of the investment decreases.