In Figure 36-2, a foreign government chooses to maintain an...

In Figure 36-2, a foreign government chooses to maintain an equilibrium market exchange rate of U.S. $$\$ 1.30$$ per unit of its own currency. Discuss the implications of the government trying to maintain a higher fixed rate-say at $$\$ 1.50$$. LO3

Key Concepts

Fixed Exchange Rate Regime

A fixed exchange rate regime is a monetary system in which the government or central bank pegs the domestic currency to another currency or a basket of currencies. This system requires the intervention of monetary authorities to maintain the target rate, often using reserves of foreign currencies or other monetary tools. It contrasts with a floating exchange rate where market forces primarily determine the currency’s value, and it plays a key role in promoting stability or influencing competitive trade positions.

Market Equilibrium Exchange Rate

The market equilibrium exchange rate is the rate at which the supply and demand for a currency balance in the foreign exchange market. In an ideal scenario without government intervention, this rate would reflect all underlying economic fundamentals such as interest rates, inflation, and economic growth. Any deviation from this equilibrium through fixed-rate policies can lead to imbalances in the foreign exchange market.

Currency Overvaluation

Currency overvaluation occurs when the fixed exchange rate set by the government is higher than the market-determined equilibrium rate, making the domestic currency stronger than its true economic value. This can lead to reduced export competitiveness, increased imports, and pressure on the government’s financial reserves due to the need to buy its own currency to support the fixed exchange rate.

Central Bank Intervention

Central bank intervention involves the active buying or selling of currencies in the foreign exchange market to influence the exchange rate. In the context of maintaining a higher fixed rate than the equilibrium level, the central bank would need to use its reserves to purchase domestic currency. Persistent interventions can eventually deplete these reserves, questioning the sustainability of the fixed rate policy.

Speculative Pressure

Speculative pressure arises when market participants anticipate that a fixed exchange rate is unsustainable, leading them to bet against the currency. When the fixed rate is set above the equilibrium rate, speculators may expect a future devaluation and thus engage in large-scale selling of the domestic currency. This speculative behavior can exacerbate imbalances and increase the likelihood of a sudden and destabilizing adjustment in the currency’s value.

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