The market-clearing exchange rate is Rs 80 per dollar. The government fixes the rate at Rs 70 per dollar. At Rs 70, the demand for dollars is 450 million USD and the supply of dollars is 300 million USD. What must the RBI do to keep the rate at Rs 70?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Sell 150 million USD, so that its foreign exchange reserves fall
At Rs 70, below the market rate of Rs 80, people want more dollars than are offered. To hold the rate, the RBI must sell dollars from its own reserves to meet this excess demand.
Given:
Demand for dollars = 450
Supply of dollars = 300 (million USD)
\( \displaystyle \text{Excess demand} = 450 - 300 = 150 \)
The RBI sells 150 million USD, and its reserves fall by that amount. This is an official reserve sale. When the rate is fixed above the market rate, the opposite happens: there is excess supply, the RBI buys dollars and its reserves rise.
NCERT (2026-27): “Fixed Exchange Rates … On the other hand if the goverment was to set an exchange rate at a level such as e2, there would be an excess demand for dollars in the foreign exchange market. To meet this excess demand for dollars, the government would have to withdraw dollars from its past holdings of dollars. If it fails to do so, a black market for dollars may come up. …” “6.1.3 Balance of Payments Surplus and Deficit … The reserve bank sells foreign exchange when there is a deficit. This is called official reserve sale. …” |