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    Fixed and Floating Exchange Rate System

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    a) Assume countries U and Q are trading partners, and that there are no other countries in the world. The following functions represent the demand and supply functions for the currency of country U.

    Supply of country U's currency :E = 1.3 - 0.1Qd
    Demand of country U's currency :E = -1.1 + 0.2Qs

    Where E = exchange rate = country W's currency/country U's currency

    (i) Briefly explain how the demand and supply for the currency of country U arise.
    (ii) Determine the exchange rate that would prevail under a clean float. Explain how equilibrium would be restored if the current exchange rate were above, or below the equilibrium rate.

    b) A country has a current account surplus of £ 6 billion, but a capital account deficit of £ 4 billion.
    (i) Is the exchange rate system fixed or floating?
    (ii) Is its balance of payments in deficit or surplus?
    (iii) Are its foreign exchange reserves failing or rising?
    (iv) Is the central bank buying or selling the domestic currency?

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    Solution Preview

    a) We have,

    Supply of country U's currency: E = 1.3 - 0.1Qd
    Demand for country U's currency: E = -1.1 + 0.2Qs

    (i) Demand for country U's currency arise when the country supplies Qs number of goods to country Q. When U supply Qs quantifies then to buy these quantities of goods country W needs Country U's currency and due to this the demand for country U's currency arise.

    Similarly, supply of country U arise when the country demand ...

    Solution Summary

    This solution outlines the steps to finding the exchange rate using demand and supply of the currency.