![]() ![]() As in the popular television game show, you are given an answer to a question and you must respond with the question. This means there is excess supply of pounds in exchange for U.S. At the fixed exchange rate ( Ē $/£), private market demand for pounds is now Q 2, whereas supply of pounds is Q 1. Now suppose, for some unspecified reason, the demand for pounds on the private Forex falls one day to D′ £. In this way, the equilibrium exchange rate is automatically maintained at the fixed level.Īlternatively, consider Figure 11.2 "Another Central Bank Intervention to Maintain a Fixed Exchange Rate", in which again the supply of pounds ( S £) equals demand ( D £) at the fixed exchange rate ( Ē $/£). This would cause a shift of the pound supply curve from S £ to S′ £. That is, it sells pounds and buys dollars on the private Forex. central bank would immediately satisfy the excess demand by supplying additional pounds to the Forex market. To maintain a credible fixed exchange rate, the U.S. This means there is excess demand for pounds in exchange for U.S. But suppose, for some unspecified reason, the demand for pounds on the private Forex rises one day to D′ £.įigure 11.1 Central Bank Intervention to Maintain a Fixed Exchange RateĪt the fixed exchange rate ( Ē $/£), private market demand for pounds is now Q 2, whereas supply of pounds is Q 1. ![]() In Figure 11.1 "Central Bank Intervention to Maintain a Fixed Exchange Rate", we depict an initial private market Forex equilibrium in which the supply of pounds ( S £) equals demand ( D £) at the fixed exchange rate ( Ē $/£). Suppose the United States establishes a fixed exchange rate to the British pound at the rate Ē $/£. To see how this works, consider the following example. The central bank can intervene in the private foreign exchange (Forex) market whenever needed by acting as a buyer and seller of currency of last resort. In a fixed exchange rate system, it becomes the responsibility of the central bank to maintain this balance. In a floating exchange rate system, the exchange rate adjusts to maintain the supply and demand balance. However, it is very unlikely that the announced fixed exchange rate will at all times equalize private demand for foreign currency with private supply. However, by fixing the exchange rate the government would have declared illegal any transactions that do not occur at the announced rate. In a fixed exchange rate system, most of the transactions of one currency for another will take place in the private market among individuals, businesses, and international banks. Learn what a central bank must do to maintain a credible fixed exchange rate in a reserve currency system. ![]()
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