# 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.

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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 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 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 D 1 D 1. where SS = DD.

\$US/\$RM S 1 0.28 0.26 D D S S Qty of \$RM Fixed rate Setting rate below equilibrium 182022

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 S 1 S 1 Setting rate below equilibrium

an increase in the value of a nations currency b4, £1 = US\$2 now £1 = US\$3 deliberate action by the govt a decrease in the value of a nations currency b4, £1 = US\$2 now £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 D D S S 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 S 1 S 1, 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 D 1 D 1 where SS =DD Managed Float

Upper Limit Lower Limit D1 D D S S 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 D 1, 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 S 1 s 1 where SS =DD Managed Float

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