Suppose that a conservative political alliance succeeds in 2020 to change the cu

Question

Suppose that a conservative political alliance succeeds in 2020 to change the current floating exchange rate regime in the U.S. into a fixed exchange rate regime. Assume that the fixed exchange rate is announced to be equal to the current market equilibrium rate. However, on March 1 of the same year, a speculative attack on the dollar takes place. Demonstrate, step by step, why a speculative attack on the dollar takes place and explain with each step how and why each market participant makes his move. Add as many steps as you think are necessary to explain your answer.

Step 1: Time: January 1, 2000, 1$ = 100¥ (Dollar vis-a-vis Yen)

Step 2: Time: March 1, 2000

Explanation / Answer

A speculative attack on dollar means a mass-scale selling of all dollar-denominated assets.

Step 1: Jan 1, 2020, 1$ = 100Y

Step 2: Mar 1, 2020: Speculative attack on dollar takes place.

Step 3: Markets are flooded with dollar-denominated assets sold by domestic and global investors.

Step 4: This creates severe downward pressure on the dollar, resulting in devaluation.

Step 5: To keep dollar exchange rate the same, Fed intervenes to keep exchange rate with Yen stable.

Step 6: To ensure that, Fed sells its foreign currency reserves to buy dollars from the market.

Step 7: This action increases demand for dollar, resulting in revaluation (upward pressure).

Step 8: Fed continues purchasing dollars until the speculative pressure on dollar eases.

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