This policy also provides a baseline or benchmark for evaluating government exchange rate policies. Given that a flexible exchange rate results in one pattern of international trade, the question is the pattern achieved through a fixed exchange rate. Do exports and imports increase or decrease? Is the balance of trade surplus or deficit larger or smaller? And what happens to the balance of payments?

The Foreign Exchange Market for Csonds

The Foreign Exchange Market

The demand for csonds is given by the negatively-sloped demand curve, labeled D. The demand of csonds is then represented by the positively-sloped supply curve, labeled S. The intersection of the demand and supply curves is the equilibrium exchange rate for csonds, in terms of queolds. The exchange rate is 5 queolds per csond, with 100 csonds exchanged.

Like any unrestricted market, the price (exchange rate) in this foreign exchange market adjusts to eliminate shortages and surpluses. A shortage -- quantity demanded exceeds quantity supplied -- induces an increase in the exchange rate. A surplus -- quantity supplied exceeds quantity demanded -- induces a decrease in the exchange rate.

Change in Demand

• Demand Increase: An increase in demand is seen by a rightward shift of the demand curve. To illustrate this shift, click the [Demand Increase] button. At the existing exchange rate, a market shortage emerges. This market shortage causes an increase in the exchange rate to 6 queolds per csond.


• Demand Decrease: A decrease in demand is seen by a leftward shift of the demand curve. To illustrate this shift, click the [Demand Decrease] button. In this case, the existing exchange rate generates a market surplus. This market surplus subsequently causes a decrease in the exchange rate to 4 queolds per csond.

Change in Supply

• Supply Increase: An increase in supply is seen by a rightward shift of the supply curve. To illustrate this shift, click the [Supply Increase] button. At the existing exchange rate, a market surplus emerges. This market surplus causes a decrease in the exchange rate to 4 queolds per csond.


• Supply Decrease: A decrease in supply is seen by a leftward shift of the supply curve. To illustrate this shift, click the [Supply Decrease] button. In this case, the existing exchange rate generates a market shortage. This market shortage subsequently causes an increase in the exchange rate to 6 queolds per csond.

What it Means for Trade

A shift in the demand and supply curves in the foreign exchange market can be caused by changes in exports and imports. However, they can also be caused by other factors, such as the flow of international investment funds. In such cases the resulting impact on international trade from movements in the exchange rate are noteworthy.

• Exchange Rate Increase: An increase in the exchange rate, caused by an increase in demand or a decrease in supply, means more queolds are needed to purchase one csond. This makes the purchase price of Csondan production relatively higher and the purchase price of Queoldiolan production relatively lower. The result is a decrease in the flow of Csonda production purchased by Northwest Queoldiola and an increase in Queoldiolan production purchased by the United Provinces of Csonda. In other words Csonda exports decrease and imports increase, with a decrease in net exports and a movement in the direction of a balance of trade deficit (or a least a smaller surplus).


• Exchange Rate Decrease: A decrease in the exchange rate, caused by a decrease in demand or an increase in supply, means fewer queolds are needed to purchase one csond. This makes the purchase price of Csondan production relatively lower and the purchase price of Queoldiolan production relatively higher. The result is an increase in the flow of Csonda production purchased by Northwest Queoldiola and a decrease in Queoldiolan production purchased by the United Provinces of Csonda. In other words Csonda exports increase and imports decrease, with an increase in net exports and a movement in the direction of a balance of trade surplus (or a least a smaller deficit).

For this reason, governments might profess support, in principle, of flexible exchange rates, but in practice usually implement one of two policies of direct intervention in the foreign exchange market -- fixed exchange rate or managed flexible exchange rate.

Two Other Exchange Rate Policies

• Fixed Exchange Rate: A fixed exchange rate is an exchange rate that is established at a specific level and maintained through government actions (usually through monetary policy actions of a central bank). To fix an exchange rate, a government must be willing to buy and sell currency in the foreign exchange market in whatever amounts are necessary to keep the exchange rate fixed. A fixed exchange rate typically disrupts the balance of trade and balance of payments for a country. But in many cases, this is exactly what a country is seeking to do.


• Managed Flexible Exchange Rate: A managed flexible exchange rate, what is also termed a managed float, is an exchange rate that is generally allowed to adjust due to the interaction of supply and demand in the foreign exchange market, but with occasional intervention by government. Most nations of the world currently use a managed flexible exchange rate policy. With this alternative an exchange rate is free to rise and fall, but it is subject to government control if it moves too high or too low. With managed float, the government steps into the foreign exchange market and buys or sells whatever currency is necessary keep the exchange rate within desired limits.