Managed Exchange Rate – Permitted Band of FluctuationSL
Global EconomicsThis diagram illustrates a managed exchange rate system where the currency is allowed to fluctuate only within an upper and lower band. The central bank intervenes whenever the exchange rate moves outside the permitted range to keep the value of the currency stable.
Curves and elements
- demand currency
- Demand for the currency (D$): Downward-sloping because fewer euros are demanded per dollar at higher prices.
- supply currency
- Supply of the currency (S$): Upward-sloping because more dollars are supplied when the exchange rate rises.
- equilibrium rate
- Ee: The natural equilibrium exchange rate without intervention.
- upper band
- Upper Band (+1%): Maximum allowed exchange rate before central bank intervention.
- lower band
- Lower Band (−1%): Minimum allowed exchange rate before central bank intervention.
Key explanations
- 1
The equilibrium exchange rate is shown at Ee, where supply and demand for the currency intersect.
- 2
The central bank sets an upper and lower band (for example, ±1%) around the target rate.
- 3
If the exchange rate rises toward the upper band, the currency becomes too strong, so the central bank sells its own currency to increase supply and push the value down.
- 4
If the exchange rate falls toward the lower band, the currency becomes too weak, so the central bank buys its own currency to reduce supply and push the value up.
- 5
The purpose of these interventions is to reduce excessive volatility while still allowing limited movement in the exchange rate.
Example exam question
Using the managed exchange rate diagram, explain how a central bank keeps the currency within a permitted band of fluctuation.
Show example answer
In a managed exchange rate system, the central bank allows the exchange rate to fluctuate only within a set upper and lower band. When the currency becomes too strong and approaches the upper band, the central bank sells its own currency to increase supply and lower its value. When the currency becomes too weak and nears the lower band, the central bank buys its own currency to reduce supply and strengthen it. These actions keep the exchange rate stable within the permitted range.
