How does a fixed exchange rate system work? How can a nation maintain its fixed exchange rate?

Question

What will be an ideal response?

Answer 1

In the fixed exchange rate system a nation might fix (or “peg”) its exchange rate with another nation. In this case, the governments of these nations must intervene in the foreign exchange markets to prevent shortages and surpluses caused by shifts in demand and supply for foreign currencies.
One way for a nation to stabilize foreign exchange is for its government to sell its reserves of a foreign currency in exchange for its own currency (or gold) when there is a shortage of the foreign currency. Conversely, a government would buy a foreign currency in exchange for its own currency (or gold) when there is a surplus of the foreign currency.
Currency reserves, however, may be limited and inadequate for handling large and persistent deficits or surpluses, so it may use other means to maintain fixed exchange rates. First, a nation might adopt trade policies that discourage imports and encourage exports. Second, a nation might impose exchange rate controls and rationing; but these policies tend to distort trade, lead to government favoritism, restrict consumer choice, and create black markets. A third way for a nation to stabilize foreign exchange rates is to use monetary and fiscal policy to reduce its national income and price level, and raise interest rates relative to other nations. These events would lead to a decrease in demand for an increase in the supply of different foreign currencies.