Suppose that Econland has a ﬁxed exchange-rate system. Econland's government (its central bank) will exchange as much local currency (say pesos) for foreign currency (say dollars) and as much
Foreign currency (say dollars) for local currency (say pesos) as is necessary to maintain the peg.
Which of the following statements is not true?
A) Satisfying requests by people to get local pesos in exchange for foreign dollars is easy for the central bank to do.
B) The central bank has a restricted capacity to satisfy requests by people to get foreign dollars in exchange for local pesos.
C) Being the central bank, it has an equal capacity to satisfy requests to exchange dollars for pesos, and pesos for dollars.
D) The central bank needs to stockpile some foreign-exchange reserves in order to maintain the peg.

Question

Quizplus · Accepted Answer

The statement that the central bank has an equal capacity to satisfy requests to exchange dollars for pesos and pesos for dollars is not true. In a fixed exchange-rate system, the central bank will have to intervene in the foreign exchange market to maintain the peg. If there is excessive demand for foreign dollars and the central bank does not have enough reserves to meet this demand, it may be forced to devalue the local currency. Therefore, the central bank's capacity to satisfy requests to exchange local currency for foreign currency may be restricted, depending on the availability of reserves.

Suppose That Econland Has a ﬁXed Exchange-Rate System