Explain by using graphs how a central bank can make exchange rate constant?

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Expert Solution

Suppose that the US central bank has fixed the exchange rate to the British pound at (a) as given in the graph. So, at that rate, the demand and supply of pounds in the US are represented by D1 and S1 curves. Now suppose for some reason, the demand for pounds rises on a given day to D2, and provided that the supply is same (excess demand), the exchange rate would rise to b, so now in order to maintain the exchange rate fixed, the central bank will satisfy this extra demand by selling pounds and buying dollars which ultimately will shift the supply curve to S2 thus maintaining the same exchange rate.

In case if the demand on the given date would fall short of supply, the central bank then would purchase pounds by selling the dollars to maintain the same exchange rate by eliminating the excess supply.

In this way, the central bank maintains the exchange rate at its constant level.

Rahul Sunny answered 1 year ago

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