Question

Starting from a position of equilibrium in the foreign exchange market under a fixed exchange rate regime, how must a government react to an increase in the demand for the nation's goods and services by the rest of the world to keep the exchange rate at its fixed value?

Short answer

Answer: To maintain the fixed exchange rate in the face of increased demand for the nation's goods and services, a government can implement the following policies: a. Foreign exchange market intervention: The central bank can sell its own currency in the foreign exchange market, increasing its supply and counteracting the increased demand to help maintain the fixed exchange rate. b. Monetary policy: The government can increase the money supply or decrease interest rates, making its currency less attractive to foreign investors and reducing the demand for its currency. This can help maintain the fixed exchange rate.

Step-by-step solution

1. Understand the foreign exchange market

The foreign exchange market is the market where currencies are traded, and exchange rates are determined. An exchange rate represents the value of one currency compared to another. Under a fixed exchange rate regime, a government maintains the exchange rate between its currency and another currency (or a basket of currencies) at a specific level.

2. Analyze the effects of an increase in demand for goods and services

When there is an increase in demand for a nation's goods and services by the rest of the world, it leads to an increase in demand for the nation's currency as well. Foreign buyers of the nation's goods and services will need to exchange their currency for the nation's currency to make purchases. This increased demand for the nation's currency puts upward pressure on its value relative to other currencies, which can lead to an appreciation of the exchange rate.

3. Assess the potential problems with an appreciating exchange rate

Under a fixed exchange rate regime, a government aims to maintain the value of its currency relative to other currencies within a specific range. If the exchange rate appreciates beyond this range, the nation's goods and services may become more expensive to foreign buyers, potentially reducing exports and causing an imbalance in trade.

4. Identify the government policies to maintain the exchange rate

To maintain the fixed exchange rate, a government can use various policies, including: a. Intervention in the foreign exchange market: The government, through its central bank, can buy or sell foreign currency in the market to influence the supply and demand of its own currency, thereby affecting the exchange rate. b. Monetary policy: By adjusting interest rates or the money supply, the government can influence the demand for its currency and ultimately affect the exchange rate.

5. Apply the government policies to the scenario of increased demand

In order to maintain the fixed exchange rate in the face of increased demand for the nation's goods and services, the government must counteract the upward pressure on the exchange rate through its policies: a. Foreign exchange market intervention: The central bank can sell its own currency in the foreign exchange market, increasing its supply and counteracting the increased demand to help maintain the fixed exchange rate. b. Monetary policy: The government can increase the money supply or decrease interest rates, making its currency less attractive to foreign investors and reducing the demand for its currency. This can help maintain the fixed exchange rate. By implementing these policies, the government can maintain the fixed exchange rate despite the increase in demand for the nation's goods and services.

Key concepts

Foreign Exchange Market

The foreign exchange market, often called forex or FX, is where currencies are bought and sold. It functions globally and is crucial for enabling international trade and investment. In this market, exchange rates are determined, which show the value of one currency in terms of another. When we talk about a fixed exchange rate regime, it means the government sets a specific value of its currency against another currency or a basket of currencies and attempts to maintain that value through their policies.
Under a fixed exchange rate system, stability for international traders and investors is provided. Countries involved know the exact exchange rate, helping with planning and risk management. However, maintaining a fixed exchange rate requires active involvement from governments to ensure the rate does not fluctuate due to market forces.

Currency Intervention

Currency intervention is when a country's government or its central bank buys or sells foreign currencies in the exchange market to influence the value of its own currency. This is a common strategy used to maintain a fixed exchange rate.
When there's an increase in demand for a country's goods, demand for its currency also rises. This can lead to the currency appreciating. To keep the exchange rate stable, the government might intervene by selling its own currency. This increases the supply of the currency and counteracts the appreciation pressure.
Such interventions can be substantial and costly. It's often a balancing act to achieve the right amount of intervention without depleting reserves or disrupting the economy. In addition to direct market actions, governments might also use other tools such as monetary policy adjustments to influence currency demand indirectly.

Monetary Policy

Monetary policy includes the actions a government or central bank takes to regulate a nation’s money supply and interest rates. These policies play a significant role in managing economic stability and maintaining a fixed exchange rate.
For instance, by lowering interest rates, a government can make its currency less appealing to foreign investors, decreasing the demand for it. This can help prevent upward pressure on the exchange rate. Conversely, increasing the money supply can also dilute the currency's value, making it less likely to appreciate.
Both strategies help a government control its currency's value indirectly, thus maintaining the fixed exchange rate. However, these tactics must be carefully managed to avoid adverse effects on inflation or economic growth.

Exchange Rate Appreciation

Exchange rate appreciation occurs when the value of one currency increases relative to another. In our scenario, if there's a higher demand for a nation's goods, the value of that nation’s currency appreciates as more of it is needed for transactions.
Appreciation can be beneficial by signaling economic strength, but under a fixed exchange rate system, it can also cause problems. If the exchange rate climbs above its set range, the nation's exports may become too expensive, decreasing international competitiveness. This can lead to trade imbalances, which countries often strive to avoid.
To combat an uneconomical appreciation in a fixed system, the government must intervene, either by influencing the supply of its currency directly in the foreign exchange market or through monetary policy measures. Such interventions help ensure that the currency maintains its intended value.