Question

Suppose that the central bank has fixed the exchange rate at E₀, but the level of output rises, raising the demand for real monetary assets.This is predicted to put upward pressure on interest rates and the value of the domestic currency.Explain how should the central bank should respond if it wants to maintain the fixed exchange rate?

Answer 1

The Central bank has to buy the foreign currency and sell the local currency in the market to keep its price lower.

If the interest rates are rising then the economy will see a significant inflow of foreign currency in the local market. This will increase the supply of Forex and reduce the demand for them. Increasing or appreciating the local currency. To maintain the local currency at the stable or fixed rate the supply of the foreign currency has to stop. The central bank will purchase the foreign currency from the market and increase its resources and sell out the local currency to maintain the supply and keep the prices low i.e. prevent the currency from depreciation.