Question

• Respond to each short answer question using two to three well-constructed paragraphs (150 – 250 words) containing specific details and examples that support your understanding of the concepts.

1. How does a government maintain a fixed exchange rate? Outline one advantage and one    disadvantage of doing so.

Answer 1

Fixed Exchange Rate system is that system where a country fixes or pegs the value of its currency to the value of another currency or value of another commodity. For example- Indian currency (Rupee) is pegged to the American currency (Dollar).

The government maintains a fixed exchange rate system in order to facilitate trade between countries and also as a way to keep inflation under control. It maintains a fixed exchange rate by either selling or buying of its currency/ securities in the open market system.

When the exchange rate exceeds the benchmark exchange rate fixed by the government, the government sells its domestic currency in the foreign exchange market. This increases their money supply and from that money, they buy the currency to which the domestic currency is pegged. This leads to a fall in the price of the currency. If the exchange rate falls below the benchmark rate, then the government buys its domestic currency in the foreign exchange market. This makes the domestic currency stronger bringing the exchange rates back up.

One advantage of Fixed Exchange Rate System is that the domestic currency becomes stable. This leads the Foreign Direct Investors to invest in the country making the country economically stronger. The more the Foreign Direct Investment, the more the country gets developed. One disadvantage of Fixed Exchange Rate System is that it is costly to maintain this exchange rate system. The government should have enough foreign exchange reserves to maintain and stabilize the exchange rate.

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