Fixed exchange rate system

In a fixed exchange rate system, however, the central bank intervenes in the foreign exchange market to buy and sell foreign currency as it is committed to maintaining the country’s exchange rate at a particular level. A balance of payment surplus (an of excess supply of foreign currency) will see the central bankintervening and buying foreign currency.

As domestic currency is exchanged for foreign currency, there is now more currency in circulation hence increasing the money supply in the country. On the other hand, a balance of payment deficit (an excess demand for foreign currency) will see the central bank selling foreign currency in exchange for domestic currency. This reduces the amount of money in circulation and therefore the money supply in the country