6.2 Fixed Exchange Rate - How to Keep an Exchange Rate Fixed

Question 1

How can a central bank maintain a fixed exchange rate under rising pressure?

Answer 1

To maintain a fixed exchange rate under rising pressure, the central bank can employ the following measures:

Question 2

Manipulate its currency reserves

How can a central bank maintain a fixed exchange rate under rising press

Answer 2

The central bank can manipulate its currency reserves by selling reserves of domestic currency and buying up foreign currency. This action increases the supply of the domestic currency in foreign exchange (FOREX) markets from S1 to S2.

Question 3

Lower interest rates

How can a central bank maintain a fixed exchange rate under rising press

Answer 3

Another approach is to lower interest rates. When interest rates decrease, investors tend to move their money out of domestic financial institutions in search of higher interest rates elsewhere. This leads to “hot money outflows” and increases the supply of the domestic currency in FOREX markets from S1 to S2, which helps reduce upward pressure on the exchange rate back to the fixed rate.

Question 4

How can a central bank maintain a fixed exchange rate under falling pressure?

Answer 4

To maintain a fixed exchange rate under falling pressure, the central bank can employ the following measures:

Question 5

Manipulate its currency reserves

How can a central bank maintain a fixed exchange rate under falling pres

Answer 5

The central bank can manipulate its currency reserves by selling reserves of foreign currency and buying up domestic currency. By doing so, they increase the demand for the domestic currency in foreign exchange (FOREX) markets from D1 to D2. This increased demand helps reduce the downward pressure on the exchange rate back to the fixed rate.

Question 6

Increase interest rates

How can a central bank maintain a fixed exchange rate under falling pres

Answer 6

Another approach is to increase interest rates. When interest rates rise, investors seeking higher returns for their money are more likely to deposit their funds in domestic banks. Higher relative interest rates attract “hot money inflows” into the economy, increasing the demand for the domestic currency from D1 to D2. This increased demand contributes to reducing the downward pressure on the exchange rate and helps restore it to the fixed rate.