Exchange rates state the value of one currency in terms of other currencies. Which one of the following statements with respect to the exchange rate of currency is correct?
Typically, a govt. maintains a fixed exchange rate by either buying/selling its currency on the open market. This is one of the reasons why governments maintain reserves of foreign currencies. If the rate of exchange drifts too far below the desired rate, the govt. buys its currency in the market using its reserves. This results in greater demand on the market and pushes up the price of the currency. If the rate of exchange drifts too far above the desired rate, the govt. sells its currency, thus increasing its foreign reserves. Another, way of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This particular method is rarely used as it is difficult to enforce and often leads to a black market in foreign currency. Some nations, such as China in the 1990s, are highly successful at using this method because of government monopolies overall money conversion. China used this particular method against the U.S. dollar.