Kenneth R. Szulczyk
Price of U.S. dollar
Euros per U.S. dollar
Quantity of U.S. dollars
Figure 7. Investors decrease their demand for U.S. dollars
In the real world, many factors influence exchange rates. A country could impose trade
barriers like tariffs and quotas. A tariff is a tax on imports, while a quota limits the quantity of
imports. Both trade barriers reduce a country’s imports. Furthermore, some countries could
impose strict regulations. Extensive regulations and taxes reduce trade and financial capital
flows. Finally, investors’ expectations and uncertainty can impact trade flows.
Fixed Exchange Rates
Central banks in several countries established a fixed exchange rate with a strong currency,
such as the U.S. dollar or euro. A fixed exchange rate is a pegged exchange rate. Usually a
government or central bank established a currency board that maintains the exchange rate. For
example, Argentina, Bermuda, and Hong Kong pegged their currencies to the U.S. dollar while
Bosnia and Herzegovina, Bulgaria, and Estonia fixed their currencies to the euro. Furthermore, a
central bank must hold a cache of currency reserves to buy or sell currencies to balance its
currency flows that maintain the fixed exchange rate.
We expand the supply and demand analysis to include a fixed exchange. A central bank
does not specify an exact price, but it allows its currency to fluctuate within a band, depicted in
Figure 8. Consequently, a central bank allows the market to change the exchange rate within the
band. If the exchange rate falls outside of the band, then the central bank must intervene in the
currency market to return the exchange rate back within the band. Thus, a central bank requires
a cache of currency reserves.
The United Arab Emirates (UAE) pegged its currency exchange rate to U.S. dollars, where
one U.S. dollar equals three dirhams. As an illustration, the international investors reduce their
demand for the dirhams, decreasing the exchange rate below the band. Consequently, the UAE
central bank must buy dirhams from the currency exchange market. It exchanges U.S. dollars or