The figure shows the foreign exchange market for dollars under a fixed exchange rate system. The government fixes the rate at e2.
To hold the rate at e2, the government must:
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → meet the excess demand by drawing on its past holdings of dollars
At e2, below the market rate e, the demand for dollars is greater than the supply. The figure shows this gap at e2.
To hold the rate there, the government must supply the missing dollars from its past holdings. Buying dollars to absorb an excess supply is what it does when the rate is set above e.
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. …”
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