Question

Explain measures the Trinidad government would take if a fixed exchange rate system is used and;

a) The exchange rate is threatening to rise above the stipulated rate.

b) The exchange rate is threatening to fall below the stipulated rate.

Answer 1

a) The exchange rate is threatening to rise above the stipulated rate means appreciation of the exchange rate. If the Trinidad government fears that there would be appreciation, it would buy foreign currency and store it in the reserves and it would sell its domestic currency in the foreign exchange market so that the demand for foreign currency increases while there is greater supply of the domestic currency and in this way the value of the exchange rate would decrease.

b) The exchange rate is threatening to fall below the stipulated rate means depreciation of the exchange rate. If the Trinidad government fears that there would be depreciation, it would sell foreign currency which was already stored in the government's reserves and it would buy back its domestic currency from the foreign exchange market so that the demand for foreign currency decreases while there is less supply of the domestic currency and in this way the value of the exchange rate would increase.