Suppose that an economy suddenly, deliberately fixes its exchange rate at a valu

Question

Suppose that an economy suddenly, deliberately fixes its exchange rate at a value that gives it a competitive advantage in world markets for trading goods (i.e., it devalues). (a) What would you expect would happen to the demand for its currency in world markets once its exports are cheaper? How will the central bank respond to maintain the fixed exchange rate? Explain. (b) What will happen to the economy’s money supply as the central bank acts to maintain the fixed exchange rate? Explain actions the central bank could take to ensure the money supply is unaffected.

Explanation / Answer

Dear sir/madam,

In a fixed exchange rate system foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of dollars. The major countries had fixed exchange rates against one another from the end of WWII until 1973. Today, some countries fix their exchange rates, but others don;t.

In the 1960s, for example, the German central bank would buy or sell any amount of dollars at 4 deutsche marks per US dollar. The French central bank, stood ready to buy or sell any amount of dollars at 4.90 French francs per US dollar. The fact that the central banks were prepared to buy or sell any amount of dollars at these fixed prices, or exchange rates, meant that market prices would indeed be equal to the fixed rates. It was because nobody who wanted to buy US dollars would pay more that 4.90 francs per dollar when francs could be purchased at that price from the Banque de France. Conversely, nobody would part with dollars in exchange for francs for less than 4.90 francs per dollar if the Banque de France, through the commercial banking system, was prepared to buy dollars at that price.

Foreign central banks hold reserves-inventories of dollars, other currencies, and god that they can sell for dollars- to sell when they want to or have to intervene in the foreign exchange market. The balance of payments measures the amount of foreign exchange intervention needed from the central banks. eg. If the US were running a deficit in the balance of payments vis a vis Japan, and thus the demand for yen in exchange for dollars exceeded the supply of yen in exchange for dollars from Japanese, the Bank of Japan would buy the excess dollars, paying for them with yen.

Fixed exchange rates thus operate like any other price support scheme, such as those in agricultural markets . Given market demand and supply, the price fixer has to make up the excess demand or take up the excess supply. In order to be able to ensure that the price (exchange rate) stays fixed , it is obviously necessary to hold an inventory of foreign currencies, or foreign exchange , that can be provided in exchange for the domestic currency.

As long as the central bank has the necessary reserves, it can continue to intervene in the foreign exchange markets to keep the exchange rate constant.

However, if a country persistently runs deficits in the balance of payments, the central bank eventually will run out of reserves of foreign exchange and will be unable to continue its intervention.

Before that point is reached, the central bank is likely to decide that it can no longer maintain the exchange rate, and it will devalue the currency. In 1967, for instance, the British devalued the pound from $2.80 per pound to $2.40 per pound. That meant it became cheaper for Americans and other foreigners to buy British pounds, and the devaluation thus affected the balance of payments by making British goods relatively cheaper for foreigners to buy.

If there was an excess supply of dollars and an excess demand for yen, either the Bank of Japan could buy dollars in exchange for yen or the Fed could sell yen in exchange for dollars. In practice, during the fixed rate period, each foreign central bank undertook to fix its exchange rate vis a vis the dollar, and most foreign exchange intervention was undertaken by the foreign central banks. The Fed was nonetheless involved in the management of the exchange rate system, since it freqently made dollar loans to foreign central banks that were in danger of running out of dollars.

By,

Nishant Bhatt

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