3. The currency stabilization fund Suppose the Brazilian government recognizes that its reliance on coffee exports makes it vulnerable to the Dutch Disease. On the one hand, if coffee prices increase, the Brazilian real will appreciate, the real exchange rate will increase, and the nation’s exports will become more expensive for other countries to buy. On the other hand, if coffee prices fall, the Brazilian real will depreciate, and the country’s revenues will decline. The Brazilian government creates a currency stabilization fund to maintain a stable exchange rate to avoid a negative outcome. To stabilize the value of a currency within a certain range, the stabilization fund managers take one of the following actions:
• If the real depreciates below some threshold value (a floor) per real, the fund managers will purchase the excess supply of reais in the international exchange market to increase the value of the real to at least the floor value.
• If the real appreciates above some threshold value (a ceiling) per real, the fund managers will sell the excess supply of reais to lower its value to at least the ceiling value.
Consider the following scenario:
Brazil establishes a currency stabilization fund to keep the exchange rate between $3 per Brazilian real and $5 per Brazilian real. Initially, the market exchange rate is within the allowed range at $4 per Brazilian real, as shown by the intersection of the demand ( D1 ) and supply ( S1 ) curves for the Brazilian real on the following graph. Suppose that higher coffee prices generated higher income for people in Brazil, which increased demand for foreign-made goods, in particular for the goods made in the United States. As a result, the supply of reais in the market for foreign exchange increased from S1 to S2 .
On the following graph, use the grey point (star symbol) to show the new exchange rate resulting from higher coffee prices.
The market for foreign exchange
New Exchange Rate
Action
0
20
40
60
80
100
10
8
6
4
2
0
EXCHANGE RATE
QUANTITY (Millions of reais)
D
1
S
1
S
2
Floor
Ceiling
According to the graph, which of the following correctly describes the effect of the increase in the supply of reais on the market for foreign exchange in Brazil?

The Brazilian real depreciates, and the exchange rate falls below the floor value.
The Brazilian real appreciates, and the exchange rate rises above the ceiling value.
The Brazilian real depreciates, and the exchange rate falls to the floor value.
The Brazilian real appreciates, and the exchange rate rises to the ceiling value.
On the previous graph, use the purple line (diamond symbol) to show how the stabilization fund managers have to adjust the value of the Brazilian real to ensure it meets the official requirement. (Hint: You need to draw either a new supply curve or a new demand curve. Make sure the new curve is parallel to the given supply or demand curve. Position your cursor over the given curves to see their slopes.)
The managers will effectively
million reais.
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