Suppose that the central bank has fixed the exchange rate at E but then the level...

Suppose that the central bank has fixed the exchange rate at E but then the level of domestic output suddenly falls. How should the central bank respond if it wants to maintain its fixed exchange rate? Briefly explain the underlying economic intuition / mechanisms!

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Expert Solution

Basically during a shortage in domestic output, the value of currency depreciates because of the reduction in exports. In such a situation, the exchange rate becomes weak. So in order to strengthen the exchange value, the central bank buys some of its currency from FOREX market to increase the cash reserve thereby maintaining the exchange rate at E. This transaction happens with the help of foreign currency, i.e. central bank buys its own currency by paying in foreign currency. Might sound bizarre, but that's how central banks maintain, and it's an arduos job with not a lot of countries having sufficient foreign reserves to facilitate this transaction. This is also cited one of the reasons why countries generally don't preferred fixed exchange rate systems, apart from the vital factor that inhibits a healthy competition in the market replete with exports and imports.

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Rahul Sunny answered 2 months ago

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