Cambridge International as and a level Economics Ebook

A fixed exchange rate system
In a 
fi xed exchange rate
system, the value of the 
currency is determined by the government. For 
instance, the value of the UAE’s dirham may be fi xed 
at 1 dirham = US$0.25. Its central bank will maintain 
the rate by intervening in the foreign exchange market 
and/or changing the rate of interest. If, for instance, 
there is downward pressure on the exchange rate 
because the supply of the currency is increasing on 
the foreign exchange market, the central bank will 
take action. It may also increase the rate of interest. 
Such a measure may attract 
hot money fl ows
, with 
people buying the currency to place into accounts in 
the country’s fi nancial institutions. 
Figure 4.14
shows 
that the UAE government fi xes its exchange rate at 
1 dirham = US$0.25.
If the supply of the currency increases to 
S
1
, the 
central bank may buy enough of the currency to shift
the demand curve to 
D
1
, and maintain the value of the 
currency at $0.25.
It is easier for a central bank to maintain a fi xed 
exchange rate if that rate is set close to the long-run 
Figure 4.13 
The eff ect on the value of the US dollar of 
Americans buying fewer UK products
P
0
Quantity of $s
D
D
S
S
1
S
Q
1
Q
P
1
S
1
Price of $s in £s
Fixed exchange rate: 
an exchange rate set by the 
government and maintained by the central bank.
Hot money flows: 
flows of money moved around the world 
to take advantage of changes in interest rates and exchange 
rates.
KEY TERMS
Fixed exchange rate: 
an exchange rate set by the 
government and maintained by the central bank.