Question

Question 6 Which of the following explanation is NOT consistent with fixed exchange rate system?

a. Under fixed exchange rate system, inflation can easily be spread among trading partners.

b. As the structure of a nation’s economy changes, the exchange rate should eventually be changed. But fixed system restricts this adjustment of relative price and the internal balance of payment adjustment process relies mainly on changes in the level of income (and hence employment).

c. Relatively easy to forecast exchange rate and thus it is helpful to increase trade.

d. Central banks do not need foreign currency reserve at all.

Answer 1

Option D

Effective management of a fixed-rate system also requires a large pool of reserves to support the currency when it is under pressure.

A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions

A central bank maintains a fixed exchange rate by buying or selling its currency. If the domestic currency appreciates then the central bank will intervene and and sell its reserves of domestic currency in order to reduce the value of the domestic currency by increasing its supply in the forex market. Similarly if the domestic currency depreciates then central Bank would buy domestic currency in the forex market to increase it value.