When.a government fixes its exchange rate, it must “intervene” in foreign exchange markets to maintain the rate. Government exchange-rate intenentioD occurs when the government buys or sells foreign exchange to affect exchange rates. For example, the
Japanese government on a given day might buy $1 billion worth of Japanese yen with U.S. dollars. This would cause a rise in value, or an appreciation, of the yen.
Figure 29-8 illustrates the-operation of a fixed exchange- rate system. In 1991, Argentina established a currency board which fixed the exchange rate at 1 U.S. The initial equilibrium is shown as point A in Figure 29-8. AJ an exchange rate of $1 per peso, the quantities of pesos supplied and demanded are equal Suppose that the demand for pesos falls-perhaps because inflation in Argentina is higher than.
Their two operations are not’ really as different as they sound, In effect, both involve monetary policies in Argentina. In fact, one of the complications of managing the open economy, as we will see shortly, is that the need to use monetary policies to manage the exchange rate can collide with the need to use monetary policy to stabilize the domestic business cycle.