Determination of fixed exchange rate, Microeconomics

DETERMINATION OF FIXED EXCHANGE RATE:

In the flexible exchange rate regime, exchange rates are highly volatile which leads to uncertainties in the international payments/transactions. For most developing countries, such uncertainties are unacceptable especially considering their development agenda. 

Therefore, stability in exchange rate is maintained through government intervention. Let us consider a simplified analysis of how a fixed exchange rate system operates. As given in Fig. 18.1, S is the supply curve and Dand D2 are the demand curves for foreign exchange (say, dollar). The equilibrium exchange rate with respect to S and D2 is Rs.30/$. Assume that the government intervenes to ensure that the exchange rate is maintained at Rs. 25/$. When exchange rate is Rs.25/$ demand for dollar is higher than supply of dollar. In order to ensure that the exchange rate does not rise to Rs. 30 per dollar (which is required by supply-demand equilibrium), the government needs to sell Q1 Q2 dollars. On the other hand, suppose prevailing demand conditions are depicted by the demand curve D1 , where equilibrium exchange rate dictated by supply-demand condition is Rs.20/$. In this case, the government needs to buy Q1Q3 dollars from the foreign exchange market to ensure that the exchange rate is maintained at Rs. 25/$. 

 

952_DETERMINATION OF FIXED EXCHANGE RATE.png

The buying/selling of the foreign exchange to maintain a given exchange rate implies that the government maintains foreign exchange reserves. (By definition, foreign exchange reserves include foreign currencies, gold reserves and SDRs). For example, BoP deficit (i.e., the demand for foreign currency (imports) is higher than the supply of foreign currency (exports)), is adjusted against the foreign exchange reserves maintained by the country. As such, the monetary authorities will suffer a loss of reserves. Similarly, a BoP surplus implies that there is a rise in the country's foreign exchange reserves. Recall from previous unit that in a flexible exchange rate regime, BoP surplus/deficit results in exchange rate appreciation/depreciation. 

At any given point in time the foreign exchange reserves of a country are limited. Therefore, continuous disequilibrium between demand for and supply of foreign exchange cannot be sustained. In such situations, currency is devalued (in the case of deficit) and revalued (in the case of surplus). When devaluation takes place, exports become cheaper (i.e., rise in supply of foreign currency) and imports become expensive thereby initiating a balance between demand and supply forces.

Posted Date: 11/10/2012 7:14:23 AM | Location : United States







Related Discussions:- Determination of fixed exchange rate, Assignment Help, Ask Question on Determination of fixed exchange rate, Get Answer, Expert's Help, Determination of fixed exchange rate Discussions

Write discussion on Determination of fixed exchange rate
Your posts are moderated
Related Questions
discuss the revealed preference theory of consumer behaviour

National income accounting: Final Goods: Final goods are goods and services which are being purchased for final use and not for resale or further processing or manufacturing

how can draw the table and diagram of production function function with one veriable

Discuss about Modern economic growth Modern economic growth is also a shift in the kinds of things we do at work and play and in the way we live. Back in immediate aftermath of

What is meant by minimum wage?  The minimum wage is the minimum rate a worker can legally be paid (usually per hour) as opposed to wages that are examined by the forces of sup

what is the value in 10 years of 1 million dollars if interes rates are 4%?

Q. Describe Labour Market Segmentation? Labour Market Segmentation: Deep and systematic differences among various groups of workers, in which different types of workers are eff

Sir/Ma''am i have to make a project of 4-5 page on Investigating the buying behavior of individuals in the white goods sector and seeing if there exists any negative relationship b

Suppose scientists discover that eating soybeans prevents cancer and heart disease. What effect would you predict on the price of soybeans?

DEMOGRAPHIC PROFILE: A demographic profile of India can be prepared out of the data collected by the office of the Registrar General of India who is the responsible authority