In a fixed exchange rate regime, most currency exchanges between people, corporations, and foreign banks will occur in the private market. By setting the exchange rate, the government would have made any transactions that did not happen at the advertised rate unlawful. However, it is pretty doubtful that the proclaimed fixed exchange rate would always equate private access to foreign currency with public supply. Under a floating exchange rate system, the exchange rate adjusts to ensure supply and demand equilibrium. The central bank is responsible for maintaining this balance under a fixed exchange rate regime.
When necessary, the central bank can serve as a buyer and seller of currency of last resort in the private foreign exchange (Forex) market. Please take a look at the sample below to understand how it works.
Assume the US sets a fixed exchange rate of $/£ for the British pound
We provide an initial private market Forex equilibrium in which supply (S£) matches demand (D£) at the set exchange rate ($/£) in "Central Bank Intervention to Maintain a Fixed Exchange Assume, however, that demand for sterling on the open Forex spikes to D′£ one day.
Private market demand for pounds is now Q2 at the fixed exchange rate ($/£), while supply is in Q1. This indicates an oversupply of pounds on the private Forex market in exchange for US dollars.
The US central bank would quickly meet excess demand by giving more pounds to the Forex market to maintain a credible fixed exchange rate. On the private Forex, it sells pounds and buys dollars. The pound supply curve would be shifted from S£ to S′£ as a result. In this method, the set level of the equilibrium exchange rate is maintained automatically.
Consider "Another Central Bank Intervention to Maintain a Fixed Exchange Rate," where supply (S£) matches demand (D£) at the fixed exchange rate ($/£). Assume that the demand for pounds on the private Forex decreases to D′£ one day due to some unidentified reason. Private market demand for pounds is now Q2 at the fixed exchange rate ($/£), while supply is in Q1. This indicates a surplus of pounds available on the private Forex market in exchange for US dollars.
In this example, an excess supply of pounds implies an excess demand for dollars in exchange for pounds. The Federal Reserve of the United States can meet the increased demand for dollars by selling dollars for pounds on the Forex market, indicating that it is supplying more cash and requesting more pounds. The pound demand curve would move from D′£ to D£ due to this. The equilibrium exchange rate is automatically and consistently maintained at the predetermined level since this intervention happens instantly.
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