Central Bank Intervention with Fixed Exchange Rates

In a fixed exchange rate system most of the transactions of one currency for another will take place in the private market between individuals, businesses and international banks. However, by fixing the exchange rate the government would have declared illegal any transactions that do not occur at the announced rate. However, it is very unlikely that the announced fixed exchange rate will at all times equalize private demand for foreign currency with private supply. In a floating exchange rate system, the exchange rate adjusts to maintain the supply and demand balance. In a fixed exchange rate system it becomes the responsibility of the central bank to maintain this balance.

The central bank can intervene in the private FOREX market whenever needed by acting as a buyer and seller of currency of last resort. To see how this works, consider the following example.

Suppose the US establishes a fixed exchange rate to the British pound at the rate Ē_$/£. In the adjoining figure we depict an initial private market FOREX equilibrium in which the supply of pounds (S_£) equals demand (D_£) at the fixed exchange rate Ē_$/£. But suppose, for some unspecified reason, the demand for pounds on the private FOREX rises one day to D’_£. At the fixed exchange rate, Ē_$/£, private market demand for pounds is now Q₂ whereas supply of pounds is Q₁. This means there is excess demand for pounds in exchange for US dollars on the private FOREX.

To maintain a credible fixed exchange rate, the US central bank would immediately satisfy the excess demand by supplying additional pounds to the FOREX market. That is, they sell pounds and buy dollars on the private FOREX. This would cause a shift of the pound supply curve from S_£ to S’_£. In this way the equilibrium exchange rate is automatically maintained at the fixed level.

Alternatively, consider the next diagram in which again the supply of pounds (S_£) equals demand (D_£) at the fixed exchange rate Ē_$/£. Now suppose, for some unspecified reason, the demand for pounds on the private FOREX falls one day to D’_£. At the fixed exchange rate, Ē_$/£, private market demand for pounds is now Q₂ whereas supply of pounds is Q₁. This means there is excess supply of pounds in exchange for US dollars on the private FOREX.

In this case, an excess supply of pounds also means an excess demand for dollars in exchange for pounds. The US central bank can satisfy the extra dollar demand by entering the FOREX and selling dollars in exchange for pounds. This means they are supplying more dollars and demanding more pounds. This would cause a shift of the pound demand curve from D’_£ back to D_£. Since this intervention occurs immediately, the equilibrium exchange rate is automatically and always maintained at the fixed level.

International Finance Theory and Policy - Chapter 80-7: Last Updated on 4/7/05