FIXED EXCHANGE RATE
FIXED EXCHANGE RATE
A fixed exchange rate is a exchange rate that does not fluctuate or that changes within a pre determined rate at infrequent intervals. Government or the central monetary authority intervenes in the foreign exchange market so that exchange rates are kept fixed at a stable rate. The rate at which the currency is fixed is called per value. This per value is allowed to move in a narrow range or "band" of +_ per cent.
If the sum of current account and capital account is negative , there occurs an excess supply of domestic currency in world markets. The government then intervenes using official foreign exchange reserves to purchase domestic currency.
The fixed exchange rate can be explained graphically. Let us suppose that India's demand for US goods rises. This increased demand for import causes an increase in the supply of domestic currency, rupee, in the exchange market to obtain US dollars. Let DD and SS be the demand and supply curves of dollar. These two curves interact at point A and the corresponding exchange rate is Rs 40=$1 . Consequently the supply curve shifts to S1S1 and cuts the demand curve DD at point B . This means a fall in the exchange rate.
To prevent this exchange rate from falling, the RBI will not demand more rupee in exchange of US dollars . This will restrict the excess supply of rupee and their will be an upward pressure in exchange rate. Demand curve will now shift to DD1. The end result in the restoration of the old exchange rate at point C.
Thus it is clear from the maintenance of fixed exchange rate system requires that foreign exchange reserves are sufficiently available. Whenever a country experiences inadequate foreign currency reserves it wont be able to purchase domestic currency in sufficient quantities. Under this circumstances , the country will devalue its currency. Thus, devaluation means an official reduction in the value of one currency in terms of another country.
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