Question

Is it accurate to think of a fixed exchange rate as a simultaneous price ceiling and price floor? Explain.

Short answer

Due to an unchanged quantity of exports and imports of goods or services in a fixed-exchange-rate regime, the statement is true that a fixed exchange rate can be simultaneously considered a price ceiling and price floor in an economy

Step-by-step solution

Price ceiling and a price floor

The government enacts price controls to regulate prices. A price ceiling keeps a price rising above the market level, while a price floor keeps a price falling below the market level.

A price ceiling is a legal maximum price a consumer pays for some goods or services.The price ceiling is imposed to keep the price of goods or services affordable or enacted to keep prices low.

A price floor is the lowest price that consumers can legally pay for some good or service.The price floors prevent a price from falling below a certain level.

Fixed exchange rate and price ceiling 

In a fixed-exchange-rate system, a government sets the exchange rates for its currency and adjusts monetary and fiscal policy as necessary to maintain those rates. A price ceiling imposed by the government of a nation will keep the consumption of domestic goods unchanged. The imports (or exports) will not be altered at that exchange rate because of the absence of inflation in the domestic market.

When the imports are restricted to a fixed level, the demand for FOREX reserves remains constant, thereby keeping the exchange rates fixed.

Fixed exchange rate and a price floor

When a price floor is set, the exports remain unaltered at any fixed exchange rate. In other words, due to the fixed minimum price offered by a nation in the world market, the entry and exit of its trading partners are restricted.

If the export remains constant for a period when the price floor is set, the currency supply and demand remain unaltered. Thus, existing trading partners continue trading with the country that offers a minimum support price for goods or services already in the trade.

Due to this balance, the exchange rate remains fixed for an unchanged quantity of exports.