Excess demand for dollars Fixed exchange-rate system

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.