Fixed Exchange Rates- How are they managed?

Question 1

What is a fixed exchange rate?

Answer 1

A fixed exchange rate is when a country pegs its currency to another currency (e.g. $1 = £0.80), and the central bank intervenes to maintain that rate.

Question 2

How do governments manage a fixed exchange rate?

Answer 2

To maintain the fixed rate, a central bank may:

Buy or sell foreign currency reserves

Change interest rates

Use capital controls

Question 3

What are foreign currency reserves and why are they important?

Answer 3

These are stocks of foreign currencies (e.g. US dollars, euros) that the central bank uses to buy or sell its own currency to keep it stable.

Question 4

What happens if there is excess demand for foreign currency?

Answer 4

If people want more dollars (e.g. $1 = £1.60 instead of £1.50), the central bank sells dollars and buys pounds to maintain the rate at $1 = £1.50.

Question 5

What happens if there is excess supply of foreign currency?

Answer 5

If the exchange rate tries to fall (e.g. $1 = £1.40), the central bank buys dollars and sells pounds to push the rate back to the fixed level.

Question 6

What are the challenges of maintaining a fixed exchange rate?

Answer 6

Requires large reserves of foreign currency

Can conflict with monetary policy goals

Vulnerable to speculative attacks if the rate is seen as unsustainable