When an
individual in one country wants to buy products from another, they must first
buy some of the currency of the other country. The exchange rate between
country A and country B (in a two-country model) is the same as a price in any
competitive market. The demand curve for A’s currency is determined by the
people who want to buy products produced by A, and the supply curve is
determined by the people from A who want to buy products produced in B. As the
exchange rate fluctuates, goods produced in country A will seem more or less
expensive to residents of country B and vice versa, altering the quantity
demanded and supplied. This is called a flexible exchange rate.
Some
countries adhere to a fixed exchange rate policy, under which the governments
of the nations involved agree to buy or sell enough of the currencies involved
to keep the exchange rate at an agreed-upon value. The governments involved
must add or subtract to demand and supply by amounts just sufficient to push
the intersection to the price point desired. This involves adding to or
subtracting from a currency reserves account, which will eventually run out of
money. So fixed exchange rates cannot be maintained under all conditions.
The movement
from fixed to flexible exhange rates was actually intended to stabilize prices.
Under fixed exchange rate policies, large devaluations and revaluations
occurred by when the official exchange rate was altered by government fiat.
However, stability has not emerged. This is because the demand for a country’s
currency does not depend exclusively on that nation’s exports.