Saudi Arabia fixes their currency, the Riyal, to the U.S. dollar at a rate of $0.27. Suppose the value of the Riyal in the absence of government intervention is $0.25.
a. Explain how Saudi Arabia would fix the value of the Riyal using exchange rate controls.
b. Explain how Saudi Arabia would fix the value of the Riyal using interest rate policy.
Riyal is kept fixed at a rate higher than free-market exchange rate, so Riyal is kept revalued (overvalued).
(a) If there is a downward pressure on Riyal so that its free-market exchange rate falls below $0.27, Saudi government will increase the price of Riyal by selling foreign currency and buying Riyal, which will depreciate foreign currency and appreciate Riyal until the exchange rate rises to $0.27.
(b) If there is a downward pressure on Riyal so that its free-market exchange rate falls below $0.27, Saudi government will increase the domestic interest rate (using contractionary monetary policy by decreasing money supply). Higher Saudi interest rate will increase foreign investment in Saudi Arabia, increasing the demand of Riyal, which will depreciate foreign currency and appreciate Riyal until the exchange rate rises to $0.27.
Saudi Arabia fixes their currency, the Riyal, to the U.S. dollar at a rate of $0.27....