Question : In a fixed exchange rate system, the value of a currency is:
Option 1: Determined by market forces
Option 2: Fixed relative to a specific reference currency
Option 3: Continuously adjusted by the central bank
Option 4: Based on the country's GDP growth rate
Correct Answer:
Fixed relative to a specific reference currency
Solution : The correct answer is b) Fixed relative to a specific reference currency
In a fixed exchange rate system, the value of a currency is fixed or pegged relative to a specific reference currency or a basket of currencies. The exchange rate is set by the government or central bank and maintained at a constant level.
The reference currency can be a major international currency like the US dollar or the euro, or it can be a composite of several currencies. The fixed exchange rate is usually supported by the government or central bank through interventions in the foreign exchange market. They buy or sell their own currency to maintain the fixed exchange rate level.
Unlike in a floating exchange rate system where the value of a currency is determined by market forces of supply and demand, in a fixed exchange rate system, the value of the currency is not determined by market dynamics. Instead, it is determined by the peg to the reference currency, and the central bank intervenes to ensure the exchange rate remains at the fixed level.
Continuous adjustments to the exchange rate by the central bank (c) or determination based on the country's GDP growth rate (d) are not characteristics of a fixed exchange rate system.
