Question

Suppose that the Fed is fixing the dollar-pound exchange rate at $2.50 = £1. If the Fed’s reserve of pounds falls by £500 million, by how much would the supply of dollars increase, all other things equal?

Short answer

The supply of dollars will increase by $1250 million if all things are equal.

Step-by-step solution

Official reserves of a country

The official reserves consist of stockpiles of various foreign currencies, bonds issued by foreign governments, gold reserves, and special reserves held at the international monetary fund.

The government of a country that adopts a fixed exchange rate assigns its central bank to carry out day-to-day FOREX market operations. It is a central bank’s task to exchange local currency for foreign currency and vice-versa to maintain the peg each day.

The stockpiles of foreign currencies are called foreign exchange reserves.

Surge in the supply of dollars

The fixed exchange rate for dollar and pound is $2.50 = 1 pound. Taking everything unchanged, the Fed’s reserve falls by 500 million pounds, due to which the supply of dollars will increase.

At this exchange rate, the number of dollars generated in the US economy will be 500 x 2.5 = $1250 million.

Thus, the supply of dollars will increase by $1250 million in the US economy.