Suppose the target exchange rate set by the Fed is 100 yen per dollar. If the demand for dollars temporarily increases, to maintain the target exchange rate, the Fed can

Question

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If the demand for dollars increase, the supply of yen will also increase, causing the value of yen to depreciate relative to the dollar. To maintain the target exchange rate of 100 yen per dollar, the Fed must sell dollars and buy yen in the foreign exchange market, thus increasing the demand for dollars and decreasing the supply of yen. This action would prevent the exchange rate from deviating from the target rate, without violating interest rate parity or purchasing power parity.

Suppose the Target Exchange Rate Set by the Fed Is