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

Quizplus · Accepted Answer

If the demand for dollars increases, the supply of yen decreases, which puts upward pressure on the exchange rate (i.e. increases the value of the dollar relative to the yen). To prevent the exchange rate from deviating from the target of 100 yen per dollar, the Fed must sell dollars (i.e. increase the supply of dollars) to offset the increase in demand. This will keep the exchange rate at the target level. Buying dollars (choice A) would only exacerbate the increase in demand and violate the target exchange rate. Violating interest rate parity (choice B) or purchasing power parity (choice D) are not relevant to maintaining the target exchange rate in this scenario.

Suppose the Target Exchange Rate Set by the Fed Is