9. Fixed exchange rates Consider the exchange rate between the Malaysian ringgit
ID: 1221577 • Letter: 9
Question
9. Fixed exchange rates Consider the exchange rate between the Malaysian ringgit and the euro. Suppose the Malaysian government and the euro zone governments agree to fix the exchange rate at 8 ringgit per euro. Refer to the following graph when answering the questions that follow EXCHANGE RATE (Ringgit per eurol 12.00 10.00 Supply o Euros 8.00 Target XR 6.00 4.00 2.00 Demand for Euros 0.00 QUANTITY OF EUROS (Billions At the target exchange rate, the euro is overvalued means that Malaysians pay more forEuropean exports than they would with a free-floating exchange rate and the Malaysian ringgit is undervalued which At the target ringgit price of euros, there is a rplus equal to 4 billion euros in the foreign exchange market.Explanation / Answer
The problem is related with exchange rate fixation in iternational market. Exchange rate is between Malyasian ringgit and Euro. The equilibrium rate depends upon demand and supply of the currencies. The diagram is showing exchange rate of ringgit per euro. It is the price of one Euro. If price decreases, more Euro is demanded. Here decrease in exchange rate will mean euro value has depreciated. Thus demand of euro and exchange rate has inverse relation. Just opposite relation is observed for supply curve. These two curves have intersected at a point where, exchange rate is 4 ringgit per euro. Equilibrium quantity is 3 billion euros.
Next consider target exchange rate. It is 8 ringgit per euro. This exchange rate is much higher than equilibrium rate. So in the target Euro has been overvalued. As a result supply of Euro will be much higher than equilibrium quantity. It is 5 billion. On the other hand, demand of Euro is very low at 2 billion.
So for maintaining this target exchange rate, supply of Euro should be reduced. So European Central bank will buy required Euros from international market by paying Malayasian Ringgit. Consider the action to be taken by Malayasian government. There currency is undervalued. So demand of Ringgit is more than its supply. Thus for increasing its supply, they also will buy euro in lieu of ringgit.
Answer: As per problem, action 1 and action 4 are observed in two countries to arrive at this target rate.
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Now government of Euro zone and Malayasian government has decided to revise the target from 8 ringgit to 4 ringgit per euro. So less ringgit is now available against an euro. It indicates depreciation in the value of Euro. On the contrary Ringgit has appreciated in value. Here after this change you can get 2 Euros by paying 8 Ringgit. Previously you are getting only 1 Euro. Hence this appreciation.
Answer: Euro depreciated and Ringgit appreciated.
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