Fixed exchange rate: set and defended by the central bank. Lowering it is a devaluation; raising it, a revaluation.
How a fixed rate is kept
Buy or sell its currency
Too weak: the central bank buys pesos with its dollar reserves. Too strong: it sells pesos.
Change interest rates
Higher rates attract savers from abroad, raising demand for pesos.
Limit money leaving
Rules on moving money abroad cut the supply of pesos.
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A managed rate floats, but the central bank steps in to limit the swings: China manages the renminbi this way.
Overvalued
- Held above the rate the market would set.
- Exports cost too much abroad.
- Uses up reserves; savers may move money out.
Undervalued
- Held below the market rate.
- Exports are cheap: a trade advantage.
- Trading partners may complain of unfair competition.
The points to remember
- Define it like this: "An overvalued currency has an exchange rate above its free-market equilibrium."
- Devaluation (fixed system) is a decision; depreciation (floating) is the market.
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Paper 3 asked this in May 2023 and November 2024, as part (b) for 10 marks.
Using the text/data provided and your knowledge of economics, recommend a policy that could be used to stabilise the value of the currency, which has been depreciating for two years.
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