Fixed Exchange Rate – Central Bank Intervention
Global Economics
This diagram shows how a central bank intervenes in the foreign-exchange market to maintain a fixed (pegged) exchange rate after an external shock shifts demand.
Curves and Elements
d1
D1$: Original demand for dollars.
d2
D2$: Higher demand after an external shock.
s1
S1$: Initial supply of dollars in the forex market.
s2
S2$: Supply of dollars after central-bank intervention.
ef
Ef: Fixed (pegged) exchange-rate level.
point1
Point 1: Pre-shock equilibrium on the peg.
point2
Point 2: Post-intervention equilibrium back on the peg.
The currency is initially pegged at the fixed rate Ef, where demand for the dollar (D1$) intersects supply of the dollar (S1$).
An external shock (e.g., higher foreign demand for exports or higher domestic interest rates) shifts the demand curve rightward from D1$ to D2$, creating upward pressure on the exchange rate.
To prevent the domestic currency (euro) from depreciating against the dollar (i.e., the dollar appreciating), the central bank sells dollars (increasing the supply of dollars) or buys euros, shifting the supply curve rightward from S1$ to S2$.
The new intersection (point 2) restores the exchange rate at Ef but increases the quantity of dollars traded in the market.
Maintaining a fixed rate requires adequate foreign-exchange reserves; prolonged intervention can be costly and may conflict with domestic monetary policy goals.
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