Question

The Central Bank is keeping a fixed exchange rate at E_par such that the domestic currency is overvalued by purchasing domestic currency. What does the Central Bank do to demand and/or supply of foreign currency?   Does this resemble the case of Lebanon or China?

Answer 1

Solution

This resembles the case of China more than that of Lebanon eventhough both follow fixed exchange rate system because Fixed exchange rate is successful when the partcular country has strong foreign exchange reserves to maintain it's currency within the desired limits.The Chinese central Bank keeps it's currency exchange rate fixed by pegging it's currency against a basket of currencies of it's largest trading partners.The basket currently inclues the currencies of the US Dollar,Japanese Yen,Euro and British Pound.

It maintains this throught the demand and supply of froeign currency in the international forex market.

For example,take the case of a single currency ,say the US Dollar which is a part of the basket of currencies against which the Chinese Yuan is pegged.

So,if China wants it's currency to depreciate then,it will keep stocking the dollars that it receives in the form of payments through its exports to the US.Due to this the supply of the US Dollars gets reduced in the international forex market.So,the value of dollar appreciates.which means the Chinese Yen becomes cheaper for the US.

The Vice-versa applies when Chinese wants it's currency to appreciate (or) to stop from depreciating in relation to the US

China can adopt to fixed exchange rate as it is a export oriented economy and it has large forex reserves due ot it's massive trade.

In the case of Lebanon,it's cental bank pegs it's currency to the US Dollar as it wants to curb it's currency devaluation

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