Question

. Assume that the Central Bank of Nation X is responsible for maintaining fixed exchange rates by buying and selling domestic and foreign currencies in exchange markets. Now suppose that interest rates in Nation X are rising in relation to interest rates in other nations. How does the Central Bank of Nation X respond in order to keep the value of its currency stable? Explain.

2. How are exchange rates determined if that currency is allowed to float?

Answer 1

Rise interest rate and Response of Central Bank:

• Rising interest rate implies that foreign capital is moving inside the country or there is huge inflow of capital. It will lead to appreciation of currency. But for keeping currency value stable, central bank will buy foreign currency from open market and thereby its supply will get reduced and value of currency will be stabilized.

Currency is allowed to float:

• If currency is allowed to float, it constitutes free market system where exchange rate is determined by the demand and supply forces. Huge inflow of capital will depreciate external currency and domestic currency will appreciate.