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Foreign Exchange Rate Policy

 Foreign Exchange Rate Policy

Fixed Conversion (o) Exchange Rates

     Under this rates system, all conversion transactions take place at a conversion rate that is ascertained by the fiscal power. It may determine the conversion rate by legislation or interference in currency markets.

    It may purchase or sell currencies as per the needs of the nation or may take policy decision to enhance or depreciate the national currency. The monetary authority keeps overseas currency reserves in order to arbitrate in the conversion markets when the demand and supply of overseas conversion are not equal at the predetermined price.

    This is described in the diagram below where D and S are the demand and supply curves of pound. They ascertain the conversion rate E which the authority maintains. Presume the demand for pounds is more than their supply as represented by PP’ in the diagram presented the supply curve (S Curve).

    This tends to increase in the conversion rate to E2 when the new demand curve intersects the supply curve S. To maintain the conversion rate at the fixed level E the monetary authority will continue to supply supplementary pounds to the market from its reserves till the conversion rate E is arrived.

     In the contra case, if there is surplus supply of pounds parities to PP’ in the market given the demand D curve, the exchange rate drops to E1 as represented by the rightward movement of the supply curve to S1 and it is overlapping the D curve at P1.

    The monetary authority will commence purchasing these surplus pounds from the market till the exchange rate E is accomplished.

The following are the applications of the above method.

  1. Depends on General Currency
  2.     The case for fixed conversion rate among different nations depends on the case for a common currency within a nation. A nation having a common currency with a set value facilities trade enhances manufacture and tends to faster development of the fiscal system.

        Likewise, a nation would benefit if it has a fixed value of its currency in association to other nations. Therefore, fixed conversion rates encourage overseas business by making prices of commodities integrated in trade more predictable.

  1. Encourage Long Term Capital Flows
  2.     The next case or argument for a system of predetermined conversion rates is that it motivates long term capital flows in an orderly and smooth approach. There is no ambiguity and risk resulting from a system of predetermined conversion rates.

  1. No Dread of Currency Variations
  2.     There is no dread of currency drop or enhancement under a system of fixed conversion rates. For example, it eliminates dread that keeps large quantities of foreign currency might tend to losses if a currency’s value falls. Therefore, it creates self-assurance in the power of the home currency.

  1. No Awful Consequence of Conjecture
  2.      There is no dread of any awful consequence of conjecture on the conversion rate as conjecture performance are controlled and banned by the fiscal authorities under a system of fixed conversion rates.

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