Exchange Rate Systems
3. What is likely to be the most credible exchange rate system? Answer: Among fixed exchange rate systems, a monetary union with a common currency is likely the most credible exchange rate system.
8. How can a central bank peg the value of its currency relative to another currency? Answer: To peg the value of its currency to another currency, the government must make a market in the two currencies. If there is excess supply of the foreign currency (which is equivalent to excess demand for the domestic currency) that would drive down the domestic currency price of the foreign currency, the government must buy the private excess supply of foreign currency and deliver domestic currency to those demanding it. On the contrary, if there is excess demand for foreign currency (which is equivalent to excess supply of domestic currency) that would drive up the domestic currency price of the foreign currency, the government must supply the foreign currency and demand the domestic currency to prevent the foreign currency from appreciating in value.
15. How can central banks defend their currency—for example, if the currency is within a target zone or pegged at a particular value?
Answer: The monetary authorities in the countries with weaker currencies have three basic defense mechanisms available: interventions, interest rate increases, and capital controls. Interventions (see Questions 7 and 9) to support the local currency may result (when not sterilized) in a lower money supply, reduced liquidity in the money market, and therefore higher interest rates. Central banks can also directly raise the interest rates they control (typically, the rate at which banks can borrow from the central bank), both to make currency speculation more costly and to signal commitment to the central rate. Finally, the authorities can limit foreign exchange transactions through capital controls, which may include taxes on (or outright...
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