The figure shows the foreign exchange market for dollars. The market-determined exchange rate is e, and the government fixes the rate at e1.
What does the gap AB show, and what must the RBI do to hold the rate at e1?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → An excess supply of dollars; the RBI buys dollars for rupees
At e1 the rate is set above the market rate e. At this higher rate, more dollars are supplied than demanded, so AB is an excess supply of dollars.
To hold the rate at e1, the RBI must absorb these extra dollars. It buys dollars for rupees, and its foreign exchange reserves keep growing as long as it does so.
Selling dollars from reserves is the step for the opposite case, a rate fixed below e, where there is excess demand.
NCERT (2026-27): “Fixed Exchange Rates … Thus, the new exchange rate set by the Government is e1, where e1 > e. At this exchange rate, the supply of dollars exceeds the demand for dollars. The RBI intervenes to purchase the dollars for rupees in the foreign exchange market in order to absorb this excess supply which has been marked as AB in the figure. Thus, through intervention, the Government can maintain any exchange rate in the economy. But it will be accumulating more and more foreign exchange so long as this intervention goes on.” “… 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. …”
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