How Fixed Exchange Rates are Maintained

1. A fixed exchange rate is sustained when the government or central bank intervenes to influence the supply and demand of the currency and keep it at a desired equilibrium level.
2. This is done by buying or selling foreign reserves in exchange for the domestic currency, or by making policy changes (e.g., affecting imports or interest rates) to stabilize the exchange rate.
3. If the exchange rate moves away from the target level, the authorities will intervene to restore it.

As shown in the diagram:

1. Initially, the price of 1 euro in terms of USD was 3.
2. When the demand for exports from the eurozone falls from D1 to D2, a floating exchange rate would cause the price to drop to 2.
3. Under a fixed exchange rate, the central bank intervenes by buying euros with its foreign reserves, shifting demand back up.
4. This keeps the exchange rate fixed at 3.

Similarly the supply could be shifted to keep the exchange rate fixed.

As shown in the diagram, when the demand for euros falls, the government can keep the exchange rate fixed at 3 USD per euro by:

1. Decreasing imports: less spending on imports reduces the supply of euros, supporting its appreciation.
2. Raising interest rates: attracts foreign investment, increasing the demand for euros.
3. Issuing foreign debt: e.g. when France borrow debt from other countries, they borrow it with euros, hence the demand for their euros increases with the amount of the debt.

Devaluation and Revaluation of Currency

1. Revaluation occurs when a country’s government increases the value of its currency relative to others.
2. This makes imports cheaper, lowers the price of foreign goods, and can help reduce inflation.

1. Devaluation occurs when a country’s government decreases the value of its currency relative to others.
2. This makes exports cheaper, improves (X–M), but also makes foreign goods more expensive, which can increase inflation.