Question

What are the mechanics of maintaining a fixed exchange rate? That is, what must a country’s central bank do in order to prevent the value of one’s currency from going up or down?

Answer 1

Basically two exchange rate systems are followed by modern countries. They are fixed exchange rate and flexible exchange rate. Under the fixed exchange rate system a country’s currency is tied with the other foreign currency. The exchange rate cannot fluctuate beyond the limit of pegged rate. The up and downs in the currency exchange rate is corrected by the timely interference of the monetary authority.

But under the flexible exchange rate system it is the market forces that determine a country’s exchange rate. The value of currency can be fluctuate to any extend. There is no mechanism to correct the depreciation or appreciation in the value of currency of a country.

The methods followed by the central bank to correct the fluctuation in the external value of a country’s currency under rate the fixed exchange rate are Devaluation, Revaluation and Open market mechanism(buying and selling of foreign currency by the central banks).

Devaluation

Devaluation is the deliberate reduction in the exchange rate of a national currency in relation to a foreign currency. When devaluation is applied the country’s currency becomes cheaper in the foreign exchange market. There are two implications of devaluation. First devaluation makes the country’s export relatively more expensive since the foreign currency is more expensive relative to the domestic currency. Secondly the devaluation makes the import more expansive since the foreign currency more expensive in relation to the domestic currency. The counter effect of increase in export and decrease in import correct the disequilibrium in the balance of payment.

Revaluation

Revaluation is an upward change in the external value of a country’s currency. The revaluation makes the national currency more expensive to the foreigners who further make a reduction in export and increase in import. This effort is used to reduce a current account surplus.

Open market mechanism. (Buying and selling of foreign currency by the central bank)

Under the fixed exchange rate system the currency exchange rate does not allow to fluctuate up and down by the timely intervention of the central bank. Under this system the central bank initially announces the county’s exchange rate. The central banks usually have foreign currency reserve. If the exchange rate fluctuates beyond this fixed rate it will be corrected by the central bank. If the exchange rate falls below the fixed rate the central banks will sells foreign currency in the open market. Thus the increased demand for foreign currency in the exchange meet is fully met by the central bank. Thus the exchange rate of the country will be prevented from moving downwards. On the other hand if the national currency is appreciated beyond the fixed rate the central bank will sell the national currency in order to meet the increased demand for the domestic currency. Thus the national currency will be prevented from appreciation. Thus the up and down in the exchange rate of a country’s currency is stabilized by the intervention of the central bank.