At the end of the lesson u should be able to: explain ER determination in a fixed ER system –r–revaluation and devaluation –g–government intervention by.

at the end of the lesson u should be able to:

• explain ER determination in a fixed ER system– revaluation and devaluation– government intervention by buying and

selling the currency

• The ER of a country is fixed in terms of another anchor currency.

• This is known as pegging the ER where a rate is fixed & then guaranteed by the govt.

• e.g. pegging of Ringgit against US$. from 1998 - 2005

Fixed ER System

• A fixed ER is maintained by intervention through central banks (in UK through Bank of England [BOE] via the Exchange Equalization A/C), which holds they country's reserves of foreign currencies.

• When the govt states that the official price or ER for its currency, they will buy or sell that currency as required in order to maintain the ER @ the official level.

• Assume that official ER between RM & US$ is at RM 1 = US$0.26

Fixed ER System

$US/RM

Qty of $RM

s

s

0.26

0.24

D

D

D 1

D 1

Fixed rate

12102

setting rate above equlibrium

Setting rate above equilibrium

• Govt. wishes to set the rate at US$0.26 = RM 1 i.e. above the equlibrium

• At this price, SS > DD by 10 m(12 - 2)

• if it is left to the free market forces, it will tend to fall towards the equilibrium

• Therefore if govt. wishes to maintain this rate, it will have to buy up 10m and this will shift DD to D1D1.where SS = DD.

$US/$RM

S 1

S 1

0.28

0.26

D

D

S

S

Qty of $RM

Fixed rate

Setting rate below equilibrium

18 20 22

• Govt. wishes to fix the ER at price US$0.26 = RM1 i.e. below the equilibrium

• At that price DD > SS by 4m (22-18) and this will push the price up to US$0.28.

• Therefore in order to maintain the price at US$0.26, govt. have to sell 4m and this will shift SS to S1S1

Setting rate below equilibrium

• an increase in the value of a nation’s currency b4, £1 = US$2now £1 = US$3

• deliberate action by the govt

a decrease in the value of a nation’s currencyb4, £1 = US$2now £1 = US$1.50

• deliberate action by the govt

• Central Bank sells and buys currency in the foreign exchange market.

• Limit currency depreciation by buying

the currency.

• Prevent excessive appreciation of currency by selling.

Managed Float

Upper Limit

Lower Limit

D1

D1

D

D

S

S

S 1

S 1

ER

Quantity of $

P

E

Setting rate below equilbrium

• OP is the equilibrium or par value with a upper and lower limits.

• If there is an increase in SS to S1S1, this will reduce the value of the $ in the free market to below the agreed level (E).

• To maintain the currency at the lower limit, central bank must buy $ with the foreign exchange reserves thus pushing DD to D1D1 where SS =DD

Managed Float

Upper Limit

Lower Limit

D1

D

D

S

S

S 1

S 1

ER

Quantity of $

P

E

Setting rate below equilibrium

• OP is the equilibrium or par value with a upper and lower limits.

• If there is an increase in DD to D1, this will increase the value of the $ in the free market to above the agreed level (E).

• To maintain the currency at the upperr limit, central bank must sell $ with the foreign exchange reserves thus pushing SS to S1s1 where SS =DD

Managed Float