Some countries seek to stabilize their exchange rates by fixing the value of dom

Question

Some countries seek to stabilize their exchange rates by fixing the value of domestic currency to some other currency, such as the U.S. dollar. This is known as fixed exchange rates. Unlike floating exchange rates, fixed exchange rates are not determined by the free market, but by central bank intervention.

The following question looks at the U.S. dollar-Netherlands guilder exchange rate in the early 1990s. Suppose that the Dutch government has fixed the value of the Netherlands guilder to the U.S. dollar to minimize fluctuations in the exchange rate.

The diagram below shows the market for the guilder. The exchange rate is defined as U.S. dollars per guilder. Suppose the Dutch government wants to fix the value of the guilder at $1.50 per guilder.

equilibrum price 2.5

equilibrum quantity 5 billion

Which of the following is true of the situation in the market for the Netherlands guilder? A.  There is a balance of payments deficit B.  The Netherlands guilder is overvalued C.  To maintain the fixed exchange rate, the central bank must sell guilders D.  There is excess supply of guilders E.  All these choices

Explanation / Answer

Equilibrium price in market for guilder is $2.50 per guilder.

Now, Dutch government wants to fix the price of guilder at $1.50 per guilder.

When market price becomes less than equilibrium price, demand exceeds supply and there is situation of excess demand.

On the other hand, when market price becomes more than equilibrium price, supply exceeds demand and there is situation of excess supply.

Since, Dutch government is fixing the price of guilder at $1.50 per guilder which is less than the equilibrium price ($2.50 per guilder); there will be excess demand of guilder in market for guilders.

In such scenario, if Dutch government wants to maintain the fixed exchange rate ($1.50 per guilder) the central bank of Netherlands has to sell guilders in order to prop up supply and to keep exchange rate fixed.

Thus, to maintain the fixed exchange rate, the central bank must sell guilders.

Hence, the correct answer is option (C).

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