Open market mechanism example Fixed exchange-rate system

fig.1: mechanism of fixed exchange-rate system

under system, central bank first announces fixed exchange-rate currency , agrees buy , sell domestic currency @ value. market equilibrium exchange rate rate @ supply , demand equal, i.e., markets clear. in flexible exchange rate system, spot rate. in fixed exchange-rate system, pre-announced rate may not coincide market equilibrium exchange rate. foreign central banks maintain reserves of foreign currencies , gold can sell in order intervene in foreign exchange market make excess demand or take excess supply

the demand foreign exchange derived domestic demand foreign goods, services, , financial assets. supply of foreign exchange derived foreign demand goods, services, , financial assets coming home country. fixed exchange-rates not permitted fluctuate freely or respond daily changes in demand , supply. government fixes exchange value of currency. example, european central bank (ecb) may fix exchange rate @ €1 = $1 (assuming euro follows fixed exchange-rate). central value or par value of euro. upper , lower limits movement of currency imposed, beyond variations in exchange rate not permitted. band or spread in fig.1 €0.6 (from €1.2 €1.8).

excess demand dollars

fig.2: excess demand dollars

fig.2 describes excess demand dollars. situation domestic demand foreign goods, services, , financial assets exceeds foreign demand goods, services, , financial assets european union. if demand dollar rises dd d d , excess demand created extent of cd. ecb sell cd dollars in exchange euros maintain limit within band. under floating exchange rate system, equilibrium have been achieved @ e.

when ecb sells dollars in manner, official dollar reserves decline , domestic money supply shrinks. prevent this, ecb may purchase government bonds , meet shortfall in money supply. called sterilized intervention in foreign exchange market. when ecb starts running out of reserves, may devalue euro in order reduce excess demand dollars, i.e., narrow gap between equilibrium , fixed rates.

excess supply of dollars

fig.3: excess supply of dollars

fig.3 describes excess supply of dollars. situation foreign demand goods, services, , financial assets european union exceeds european demand foreign goods, services, , financial assets. if supply of dollars rises ss s s , excess supply created extent of ab. ecb buy ab dollars in exchange euros maintain limit within band. under floating exchange rate system, equilibrium again have been achieved @ e.

when ecb buys dollars in manner, official dollar reserves increase , domestic money supply expands, may lead inflation. prevent this, ecb may sell government bonds , counter rise in money supply.

when ecb starts accumulating excess reserves, may revalue euro in order reduce excess supply of dollars, i.e., narrow gap between equilibrium , fixed rates. opposite of devaluation.