THE ISSUES

At several points in the previous chapter, changes in exchange rates were said to cause switches in expenditure between domestic and foreign goods. This chapter provides the explanation and examines the implications for economic policy and for the choice between exchange-rate regimes. It explores three issues:

• How an exchange-rate change switches expenditure, and the conditions that must be fulfilled for the change to improve the current account.

• How macroeconomic policies must be managed to make an exchange-rate change effective.

• When it would be sensible for a country to give up using the exchange rate for balance-of-payments adjustment and fix its exchange rate permanently.

The first part of the chapter works through the expenditure-switching effects of an exchange-rate change; it sets out the elasticity approach to the analysis of exchange-rate changes. The next part looks at the implications for incomes and prices at home and abroad; it develops the absorption approach and examines the role of the exchange rate as a policy instrument. The final part of the chapter introduces the theory of optimal currency areas; it examines some of the benefits and costs of fixing exchange rates.

The chapter uses the same basic assumptions made in Chapter 13. Home and foreign prices are fixed. The economy under study is too small to influence economic activity in other countries. The central bank sterilizes the monetary effects of intervention on foreign-exchange markets and uses its control of the money supply to set the domestic interest rate.