7 Fixed exchange rates Consider the exchange rate between th

7. Fixed exchange rates

Consider the exchange rate between the Malaysian ringgit and the euro. Suppose the Malaysian government and the Eurozone governments agree to fix the exchange rate at 1.25 ringgit per euro, as shown by the grey line on the following graph.

Refer to the following graph when answering the questions that follow.

Solution

At the equilibrium exchange rate, value of 1 euro is 1 ringgit. At the official exchange rate, the value of 1 euro is 1.25 ringgit. This means euro obtains more ringgit at official exchange rate than it would get at equilibrium exchange rate. It means the euro is overvalued and the malayasian ringgit is undervalued as under official exchange rate, Malaysia has to pay more to get 1 Euro. This means malaysians pay more for European exports (because to pay for European exports i.e. Malaysian import, they need to pay in euro. And, now under official exchange rate system they have to pay more ringgit to buy one Euro) than they would under free floating exchange rate.

At the official ringgit price of euros i.e. 1.25 ringgit per Euro, supply of euros is greater than demand for euros. Therefore, there is a surplus of euros in foreign exchange market.

If government change the official exchange rate from 1.25 ringgit per Euro to 1 ringgit per Euro, the government lowers the value of euro and increases the value of ringgit. This will lead to a revaluation of euro and devaluation of ringgit.