Can you please explain the mechanics of a fixed exchange rate attack? - ProProfs Discuss
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Can you please explain the mechanics of a fixed exchange rate attack?

Asked by Isaac, Last updated: Nov 24, 2021

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John Smith

John Smith

John Smith
John Smith

Answered Sep 08, 2016

Heres the gist of an attack on a fixed exchange rate: with a fixed exchange rate, the government commits to keeping the rate at a specific level. The government can maintain that level by purchasing and selling foreign currencies in the exchange rate market to influence the level of the domestic currency. But when the currency becomes overvalued (for example, the international commerce market is unwilling to pay the price), the natural tendency is for the currency to fall in price. So the government works hard to maintain the current level by selling foreign currencies and buying the domestic currency. This causes a problem with foreign currency reserves. In short, if the government has to keep selling foreign currencies, at some point they are going to run out. Speculators who believe that the currency will be devalued borrow massive amounts of the domestic currency and quickly sell them for another currency - for example, borrow mexican pesos and then sell the pesos in exchange for us dollars. The big sell off in the currency continues to put downward pressure on the domestic currency price level and at some point the government must devalue their currency. The speculators that sold their mexican pesos for us dollars when the peso price level was high then pay back the loan later with cheaper pesos.

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