Exchange Rates Discussion Only provide your opinions when specifically called fo

Question

Exchange Rates Discussion

Only provide your opinions when specifically called for. In all other cases your answer(s) showing your capacity to apply the appropriate economic principles and concepts correctly.

1. Assume that the Central Bank of Nation X is responsible for maintaining fixed exchange rates by buying and selling domestic and foreign currencies in exchange markets. Now suppose that interest rates in Nation X are rising in relation to interest rates in other nations. How does the Central Bank of Nation X respond in order to keep the value of its currency stable? Explain.

2. How are exchange rates determined if that currency is allowed to float?

Explanation / Answer

1)

Since here, central bank of country is responsible for maintaining fixed exchange rate system, rise in interest rate in country indicates that more money is likey to inflow in country. Inflow of foreign exchange would distrube fixed exchange rate. Hence, central bank of country would buy foreign exchange from open market so that appreciation of domestic currency can be prevented.

Inflow of foreign exchange leads to appreciation of domestic currency.

2)

Market forces demand and supply determine exchange rate if currency is allowed to float.

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